U.S. Markets closed

Edited Transcript of SCM earnings conference call or presentation 7-Nov-19 4:00pm GMT

Q3 2019 Stellus Capital Investment Corp Earnings Call

Houston Dec 6, 2019 (Thomson StreetEvents) -- Edited Transcript of Stellus Capital Investment Corp earnings conference call or presentation Thursday, November 7, 2019 at 4:00:00pm GMT

TEXT version of Transcript

================================================================================

Corporate Participants

================================================================================

* Robert T. Ladd

Stellus Capital Investment Corporation - Chairman, President & CEO

* W. Todd Huskinson

Stellus Capital Investment Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO

================================================================================

Conference Call Participants

================================================================================

* Christopher Whitbread Patrick Nolan

Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research

* Paul Conrad Johnson

Keefe, Bruyette, & Woods, Inc., Research Division - Associate

* Robert James Dodd

Raymond James & Associates, Inc., Research Division - Research Analyst

================================================================================

Presentation

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

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 third quarter 2019 results. (Operator Instructions)

This conference is being recorded today, Thursday, November 7, 2019.

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 your conference.

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [2]

--------------------------------------------------------------------------------

Thank you, Justin. Good morning, everyone, and thank you for joining the call. Welcome to our conference call covering the quarter ended September 30, 2019. 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.

--------------------------------------------------------------------------------

W. Todd Huskinson, Stellus Capital Investment Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [3]

--------------------------------------------------------------------------------

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 T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [4]

--------------------------------------------------------------------------------

Thank you, Todd. We'll begin by discussing our operating results, followed by a review of the portfolio, which will include asset quality, and then I'll provide an outlook. And Todd will now cover operating results.

--------------------------------------------------------------------------------

W. Todd Huskinson, Stellus Capital Investment Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [5]

--------------------------------------------------------------------------------

Thank you, Rob. We're pleased to report another quarter of solid earnings in which we generated realized income of $0.63 per share, including gains of $0.33 per share, which exceeded our $0.34 per share dividend by $0.29.

Core net investment income, which excludes the capital gains incentive fee accrual and excise taxes, was $0.35 per share and GAAP net investment income was $0.31 per share.

Total realized income to date, including $19.1 million of realized gains, is $1.92 per share, which exceeds our distributions of $1.02 per share for the same period. This represents an annualized return on equity of 12.4% during the third quarter and 12.7% year-to-date. As a result of these realized gains, we believe it's likely that more than half of the dividends paid this year will be characterized as long-term capital gains for tax purposes.

Finally, net asset value increased $2.1 million over the quarter or $0.11 per share from $14.29 to $14.40 per share primarily due to the realized gains.

And with that, I'll turn it back over to Rob.

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [6]

--------------------------------------------------------------------------------

Okay. Thank you, Todd. I'd like to now cover the areas of portfolio and asset quality and then outlook.

With respect to the portfolio, we ended the quarter with a portfolio of $586.4 million at fair value, which is across 61 portfolio companies, approximately a $55 million increase over the second quarter. This increase included $96.6 million at par value of new investments in 6 new and 2 existing portfolio companies, and also the reduction from repayments and realizations of approximately $43 million.

Our portfolio continues to be weighted toward first lien and unitranche loans, which now stand at 73% of the total portfolio. This move to more senior lending is resulting in lower coupons. However, we expect it will also result in a stronger asset quality over time.

We continue to maintain good diversification with the largest industry sector at approximately 13% of the total portfolio. The average investment per company is $9.6 million and the largest investment is $21.2 million, both at fair value. Our largest exposure at the end of June was $21.6 million and that loan was repaid during the third quarter. 57 of the 61 portfolio companies are backed by a private equity firm. 80% of our total investment portfolio is rated at a Category 2 or better, meaning on plan or ahead of plan.

With respect to nonaccrual loans, a $7.9 million loan that was on nonaccrual as of June 30 was repaid in full during the quarter, including unpaid interest. The unpaid interest had been previously reserved, so -- which resulted in additional interest and fee income of approximately $1.3 million during the quarter. As a result of this payoff, we now have loans to just 3 portfolio companies that are nonaccrual and they comprise 2.3% of fair value of the total portfolio. This is down from 4 loans and 4.8% in the prior quarter.

With respect to outlook, first, we're pleased to report that in August, we received our second SBIC license. When fully capitalized, this will allow us to have access to up to $175 million of SBA debentures, which are a long-term, low-cost source of capital. And as of today, we've funded $12 million of equity and drawn $6 million of debentures under the new license.

As we discussed on last quarter's call and as reflected in our current yield, we're expecting a lower overall yield in the loan portfolio. During 2019, the yield on our debt portfolio has decreased from 10.9% to 9.4%, which was principally driven by a lower LIBOR rate and a continued rotation towards first lien and unitranche loans.

During the quarter now, since quarter end, we've funded $63.7 million of debt at par in 3 new and 1 existing portfolio companies and have received repayments of $18.9 million in 1 company. Also as of today, our portfolio is approximately $630 million, up from $42 million -- up $42 million since quarter end. I will say that for the balance of the quarter, we're just expecting modest growth given the activity we've already experienced in the first part of the quarter.

Then with respect to earnings, for the fourth quarter, we do not expect to fully cover the dividend from GAAP NII due to the lower yields and our current leverage level, but we will likely cover that gap from additional realized gains, which we expect will exceed $1 million.

With that, I'll open it up for questions, and thank you. Justin, we'll go to the Q&A session, please.

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

(Operator Instructions) Our first question comes from Paul Johnson with KBW.

--------------------------------------------------------------------------------

Paul Conrad Johnson, Keefe, Bruyette, & Woods, Inc., Research Division - Associate [2]

--------------------------------------------------------------------------------

My first question was just on one portfolio company. I was hoping (inaudible) at Furniture Factory Outlet. The mark was just -- marked out just slightly over. In the quarter, I know there's a smaller sub-debt piece in the portfolio that's marked basically at 0%. Any kind of color on the performance of that company would be helpful.

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [3]

--------------------------------------------------------------------------------

Excuse me, Paul, we're having trouble hearing you. Why don't we start first with repeating the question and...

--------------------------------------------------------------------------------

Paul Conrad Johnson, Keefe, Bruyette, & Woods, Inc., Research Division - Associate [4]

--------------------------------------------------------------------------------

Sure. Are you able to hear me now?

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [5]

--------------------------------------------------------------------------------

Better. Please, go ahead.

--------------------------------------------------------------------------------

Paul Conrad Johnson, Keefe, Bruyette, & Woods, Inc., Research Division - Associate [6]

--------------------------------------------------------------------------------

Sorry about that, having headset issues. My question was just around the portfolio company, Furniture Factory Outlet. I was hoping you could give a little bit of color on the performance of that company, just given the markdown or slight markdown in the first lien piece while the smaller sub-debt piece is basically marked at 0?

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [7]

--------------------------------------------------------------------------------

Well, as you know, we don't talk about the private companies in our portfolio for obvious privacy reasons. But this is a business based in the retailing sector of the Mid-Continent or Midwest United States. The small note that's -- has a 0 value is kind of stub piece of [equity]. So we've really looked at the first lien loan as relevant.

--------------------------------------------------------------------------------

Paul Conrad Johnson, Keefe, Bruyette, & Woods, Inc., Research Division - Associate [8]

--------------------------------------------------------------------------------

Okay. And then I was wondering, for the debentures, the SBA debentures that you've drawn down quarter-to-date, what has been sort of the average cost range of those debentures?

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [9]

--------------------------------------------------------------------------------

Yes. So one thing I would like to say as a general matter that given the current rate environment, the -- so far -- although, these weren't priced in September, they'll be priced in March, but the debentures that were priced in September, as a general matter, and the rate that's paid during the interim period are less than our current debentures we hold.

So I would think of this as being lower -- if the current rate environment continues, these will be at a lower cost than our current debentures, which are priced in the high 3s, all-in, when you include fees. So Paul, just to give you a sense -- think of it more like 3% than 4%, so lower in the current environment, which will be helpful to us.

--------------------------------------------------------------------------------

Paul Conrad Johnson, Keefe, Bruyette, & Woods, Inc., Research Division - Associate [10]

--------------------------------------------------------------------------------

Sure. Yes. Great, great. And then lastly on the tax expense that you guys recorded this quarter, the $350,000 or so that you adjusted in earnings. Is that related to the -- like an excise tax for the quarter or is that related to some sort of capital gain accrual?

--------------------------------------------------------------------------------

W. Todd Huskinson, Stellus Capital Investment Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [11]

--------------------------------------------------------------------------------

Yes, Paul. This is Todd. It's effectively all excise tax that we've been accruing during the year. We accrue it each quarter based on what our current estimate of spillover is.

--------------------------------------------------------------------------------

Operator [12]

--------------------------------------------------------------------------------

The next question comes from Christopher Nolan with Ladenburg Thalmann.

--------------------------------------------------------------------------------

Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [13]

--------------------------------------------------------------------------------

Rob, what percentage of your deal flow would you say is SBIC-compliant? I mean -- I guess my point is, how quickly can you deploy -- can you grow the SBIC sub?

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [14]

--------------------------------------------------------------------------------

Yes. So historically, what we've found is that approximately 50% of our activity -- now we may not close everything, but 50% of what we're looking at has qualified. And this goes back for roughly 7 or 8 years. So that's a good number to think of. What we actually close could be a different percentage, could be a little bit less.

I would say, realistically, it'll take us a couple of years to deploy the debentures in full. Our last license was probably over 3 years or so, but it's a very important source for us. As pointed out earlier, we think that this is one of the things that assists us as LIBOR is lower and our first lien unitranche business is growing. That will still provide us interesting margin to cover the dividend. So we're very incentivized to deploy it. But realistically, I would say, it'll take a couple of years until it'll -- probably 18 months, at the earliest.

--------------------------------------------------------------------------------

Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [15]

--------------------------------------------------------------------------------

So funding with the SBIC is a more profitable business than funding on balance sheet, you would say?

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [16]

--------------------------------------------------------------------------------

It is. Although, I would also point out that from here, as we grow the portfolio, the goal now will be in excess of $700 million, where we're now at over $600 million. Incremental growth from here will come from one, the SBIC debentures; but two, our bank facility, which is a floating rate facility priced up to 30-day LIBOR rate, and so marginal growth will come. And that marginal cost, if you will, is now in the low 4s.

--------------------------------------------------------------------------------

Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [17]

--------------------------------------------------------------------------------

Great. And I guess a follow-up would be on the bank facility itself. I mean -- I see it's jumped quite a bit. And I can understand that is a source of future funding, but what sort of advance rate are banks charging these days?

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [18]

--------------------------------------------------------------------------------

So advance rate or borrowing rate?

--------------------------------------------------------------------------------

Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [19]

--------------------------------------------------------------------------------

The advance rate. How much...

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [20]

--------------------------------------------------------------------------------

The advance rate?

--------------------------------------------------------------------------------

Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [21]

--------------------------------------------------------------------------------

Yes, how much in assets you have to collateralize it with to get $1 of borrowing?

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [22]

--------------------------------------------------------------------------------

Sure. So it varies by the lien position and the company specifics, but it's certainly in excess of 50% and probably closer to 60% on our unitranche financings.

--------------------------------------------------------------------------------

Operator [23]

--------------------------------------------------------------------------------

Our next question comes from Robert Dodd with Raymond James.

--------------------------------------------------------------------------------

Robert James Dodd, Raymond James & Associates, Inc., Research Division - Research Analyst [24]

--------------------------------------------------------------------------------

Guys, I mean just one -- I know you don't usually like to talk about specifics of the companies in the portfolios, but one of your co-investors in Grupo Hima just gave an update earlier today about some stress that occurred late in the third quarter and even more so that has been disclosed by that borrower since the end of the quarter.

Could you give us any update on how much of that is factored into the mark today? And if you've got any kind of feel about what the driver for that is?

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [25]

--------------------------------------------------------------------------------

So Robert, the -- I would say that our reduction in the mark that occurred in the quarter was to reflect that new news. And then if you wouldn't mind repeating the second part of the question? It's...

--------------------------------------------------------------------------------

Robert James Dodd, Raymond James & Associates, Inc., Research Division - Research Analyst [26]

--------------------------------------------------------------------------------

I mean if you got any -- so I'll pick up the handset. If you've got any kind of idea about what the driver was? Because it sounded like the weakness there came on relatively suddenly.

So do you have any visibility about what caused it? And whether it's short-term, operational...

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [27]

--------------------------------------------------------------------------------

Sure. And again, I'd hope you'll respect that we try not to comment on company-specific issues because of competitive and other factors they might have in their marketplace. But again, I would just say that we believe that our reduced mark on the first lien reflects that information and reduced mark on the second lien. I would say, as a general matter, the first lien should be worth full value ultimately. So -- but we think it -- this mark at $0.82 in the first lien reflects the current information.

--------------------------------------------------------------------------------

Robert James Dodd, Raymond James & Associates, Inc., Research Division - Research Analyst [28]

--------------------------------------------------------------------------------

Got it, got it. I appreciate that color. And look, if I can -- I mean you gave some indications for Q4. Don't expect to cover the dividend with GAAP NII in the fourth quarter, but including the realized -- total realized earnings would.

Can you give us any idea about where you think the portfolio needs to be, size-wise, given the current market yields you're seeing with some spread contraction, more first lien, more unitranche. What -- how big does the portfolio need to be to cover the dividend from a GAAP NII basis?

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [29]

--------------------------------------------------------------------------------

Yes, Robert. So this would be -- thank you for that question. This would be now looking to 2020. And so one of our goals was to get the portfolio to $600 million-plus, which we've now achieved.

I would say -- expressed in a couple of way. One, think of the regulatory leverage would need to be at approximately 1:1. We've been operating at about 0.68 or 0.7:1. So that would imply a portfolio in excess of $700 million, and then we are benefited. So I did -- do think this is positive for the outlook. We are benefited from one, the lower-cost SBIC debentures, which we'll be deploying; and two, as our 90-day rate that we lend against is dropped, so is our marginal cost of our bank facility, which will also fund part of the new growth.

So I'd say, the combination of greater leverage or portfolio growth but certainly in excess of $700 million portfolio, a 1:1 regulatory leverage, which may approximate closer to -- up to 2:1, including SBIC debentures. So combination of that and the lower cost of debt should get us in a much better position.

--------------------------------------------------------------------------------

Robert James Dodd, Raymond James & Associates, Inc., Research Division - Research Analyst [30]

--------------------------------------------------------------------------------

Got it. I appreciate that color. And then given -- this year, you've had a very good -- a lot of realized gains, harvesting prior equity positions, et cetera.

I mean what level do you think -- and this is very speculative -- for 2020, do you expect that level to drop significantly, given the relative age of some of the equity positions in your portfolio? Or can you give us any color on that?

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [31]

--------------------------------------------------------------------------------

Yes, yes. That's also a very good question. So I'd say, this is certainly an unusual year if you look at our business over the last few years, but has been a growing part of the business as our equity positions have matured.

So we certainly would expect to see additional realized gains, but we certainly -- not projecting at this point they would be of the magnitude currently. And if I had to give you a number, it certainly could be half as much next year. So a lot of this -- I'd say the maturity or the age of the equity positions, there is still a number that are relatively new. So we think there's more gains to come. But just to be fair would be -- this has been an outsized year. And also, I would say that, as you know, that we also think these realized gains can be helpful and eventually will have losses and hopefully, they'll be modest. But this is a nice cushion for us with respect to that.

--------------------------------------------------------------------------------

Operator [32]

--------------------------------------------------------------------------------

Showing no further questions in queue, I would like to turn the conference back over to Mr. Ladd for closing remarks.

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [33]

--------------------------------------------------------------------------------

Okay. Great. Thank you, everyone, for your support, and we look forward to speaking with you in the spring. Thank you very much.

--------------------------------------------------------------------------------

Operator [34]

--------------------------------------------------------------------------------

Thank you, ladies and gentlemen. This concludes today's teleconference. You may now disconnect.

--------------------------------------------------------------------------------

Robert T. Ladd, Stellus Capital Investment Corporation - Chairman, President & CEO [35]

--------------------------------------------------------------------------------

Justin, thanks very much.