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Edited Transcript of SCM earnings conference call or presentation 3-Mar-20 4:00pm GMT

Q4 2019 Stellus Capital Investment Corp Earnings Call

Houston Apr 6, 2020 (Thomson StreetEvents) -- Edited Transcript of Stellus Capital Investment Corp earnings conference call or presentation Tuesday, March 3, 2020 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Robert T. Ladd

Stellus Capital Investment Corporation - Chairman & CEO

* W. Todd Huskinson

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

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Conference Call Participants

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* Christopher Whitbread Patrick Nolan

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

* Robert James Dodd

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

* Ryan Patrick Lynch

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

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Presentation

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Operator [1]

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Good morning, ladies and gentlemen, and thank you for standing by. At this time, I would like to welcome everyone to Stellus Capital Investment Corporation's conference call to report fourth quarter 2019 results. (Operator Instructions)

This conference is being recorded today, Tuesday, March 3, 2020. 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.

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

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Thank you, Samantha, and good morning, everyone, and thank you for joining the call. Welcome to our conference call covering the quarter and year ended December 31, 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.

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

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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.

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

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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 first.

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

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Thank you, Rob. For fiscal year 2019, we more than covered the dividend of $1.36 per share, with realized income of $2.30 per share, which included $19.6 million of net realized gains or $1.07 per share. Core net investment income was $1.32 per share, and GAAP net investment income was $1.23 per share. As a reminder, the core investment net investment income calculation is non-GAAP and excludes the capital gains incentive fee accrual and excise taxes.

Net asset value increased $45.8 million from $224.8 million to $270.6 million due primarily to our equity offering in March 2019. On a per-share basis, net asset value increased from $14.09 to $14.14 due primarily to net gains of $0.22 per share. Finally, of our $1.36 per share of dividends paid in 2019, approximately 60% were characterized as long-term capital gain and therefore taxable to our investors at the applicable long-term capital gains rate.

Turning to the fourth quarter, we covered our distributions of $0.34 per share through realized income of $0.38 per share, which included realized gains of $0.02 per share. GAAP net investment income was $0.36 per share, impacted by the reversal of $1 million of previously recorded capital gains incentive fee accrual. Core net investment income was $0.32 per share. As a reminder, it excludes the impact of capital gains incentive fee and excise tax.

Net asset value decreased $0.26 per share during the quarter from $14.40 to $14.14 due primarily to unrealized depreciation on our debt portfolio.

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

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

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Okay. Thank you, Todd. I'd like to cover the following areas. I'd like today to review portfolio and asset quality and then turning to outlook.

So really, this is a 7 full years' like-to-date review. So since our IPO in November of 2012, we've invested approximately $1.3 billion in 117 companies and have received approximately $820 million of repayments, while maintaining stable asset quality. To date, we have paid over $141 million of dividends to our investors, which represents $10 per share to an investor from our IPO in November 2012, which was at $15 a share.

Now turning to portfolio and asset quality, we ended the year with an investment portfolio at fair value of approximately $629 million across 63 portfolio companies, which is up from approximately $505 million across 57 companies at December 31, 2018. During 2019, we invested $251 million in 17 new and 12 existing portfolio companies and received approximately $128 million of repayments. So a total net portfolio growth of approximately $124 million for the year.

Our portfolio continues to be weighted towards secured lending at floating rates. At December 31, 96% of our loans were secured and 93% were priced at floating rates. This move has coincided with greater first lien and unitranche lending. We continue to make good diversification with the largest industry sector at 15% of the total. The average investment per company is $10 million and the largest investment is $21 million, both measured at fair value. 59 of the 63 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. 11% of our portfolio is rated a 1 or ahead of plan and 11% of the portfolio is marked at an investment category of 3 or below. In total, we have 2 loans on nonaccrual, which comprise just under 1% of fair value of the loan portfolio.

Now turning to outlook. 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 7 years, we've begun to see somewhat regular realized gains from the portfolio. During 2019, we generated $19.6 million of net realized gains. And since year-end, we've had $1.3 million of realized gain.

Also since year-end, we have funded $35 million at par in 2 new portfolio companies and we received $12.5 million in full repayment of 1 investment, which brings the portfolio to approximately $650 million. We've identified likely fundings of approximately $13 million by quarter end and repayments of $15 million. So we'll likely end the quarter about where we are today.

Beyond this quarter, I'd like to comment on some headwinds in the business. First, as you know, we've had a falling LIBOR rate from which most of our loans are priced. The 90-day rate was 195 basis points at December 31. Yesterday, it was about 1.24%. We do have LIBOR floors, which on average are at about 1%. And recently, we've been structuring loans with floors higher than that level.

Second, as we rotated the portfolio to more first lien and unitranche lending, our yield has decreased. This should result in a lower risk profile, though. And third, we've seen a limited impact from sourcing from China so far. Certainly, the longer-term impact to the portfolio of coronavirus or COVID-19 is something we're studying very carefully.

Finally, on a positive note, in addition to the $1.3 million realized gain that was received in January, we're expecting an additional $4 million of realized gains for the year.

And with that, I'll open it up for questions. Samantha, you may begin the question-and-answer session.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question will come from Robert Dodd with Raymond James.

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Robert James Dodd, Raymond James & Associates, Inc., Research Division - Research Analyst [2]

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On the China sourcing supply chain, I mean, can you -- you gave a little color there on seeing limited impact so far. It's obviously very early. Could you tell us how far you are through the process of maybe evaluating that, not just like obviously talking to the companies, but evaluating how significant maybe secondary impacts could be or anything like that?

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

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Yes, Robert. So as we said, we're studying it carefully and talking with the companies. We certainly have less than a dozen companies that have some direct supplier demand exposure to China, although so far, through the tariff process, there's very limited impact. And then question -- so our bigger question, though, would be if this becomes more pervasive and starts to impact -- has an impact on the U.S. economy and travel and the way one operates in business could have more of an impact. We've identified a couple of companies that actually would benefit from the virus situation in the States. But it hasn't come to that. So again, we're still evaluating it, Robert. But I'd say that if it continues, and it certainly has more of an impact on the way business is done in the States, it could be impactful. But I would think, as a general matter, most of our exposure by design, of course, is based in the United States.

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Robert James Dodd, Raymond James & Associates, Inc., Research Division - Research Analyst [4]

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Got it. Got it. On the LIBOR floor issue, obviously, the Fed's just cut. There's -- and I think you said most of your floors are at 1%. You've been -- can you give us a little bit more color on what percentage of your portfolio actually has floors? How many are 1%, and when you say you're structuring higher floors, how much higher have you been able to get in a pretty competitive market?

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

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Sure. So with respect to the existing floors, many are higher than 1%, but that's an average number, and I'd say very few, less than 5 would have no floors and we'll maybe double-check while I'm talking. So most every loan we have has a floor. And then we do have still some fixed-rate loans, although it's -- by design, it's become a smaller percentage just as we've gone to more secured lending. In terms of the market today, so I'd say going back to Labor Day or so, we started structuring LIBOR floors generally at 150 and some higher at 175 and so -- and we've tried to be disciplined also about the spread too, which is relevant. So we've reached the point we would say, in terms of absolute return, that these are important parts of structuring deals, that there's at a rate below which we wouldn't go. So I think if you thought about our recent investing and likely investing it during this year, the floors will be higher. And certainly, all-in yield, we're looking for what is the all-in return for a loan.

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Robert James Dodd, Raymond James & Associates, Inc., Research Division - Research Analyst [6]

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Got it. I appreciate that. And if I can, one more. On the markdowns in the fourth quarter, it looks like Protect America. Is there anything that you can tell us about the driver there? I mean it's, I think, a home security company. We've seen other home security companies -- not in your portfolio, but elsewhere in the marketplace -- occasionally have issues in the last few years. I mean is there something structurally changing in that market that's creating incremental problems?

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

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Yes. So again, as you know, we don't really comment about specific companies in the portfolio for privacy reasons. But I would say, as a general matter, that the security monitoring business, there has been a technological change over time and it's certainly impacting incumbent-type businesses. So that's probably the most I should say at this point.

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Operator [8]

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Our next question will come from Christopher Nolan with Ladenburg Thalmann.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [9]

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What are you thinking about leverage given LIBOR is going down? So where should we expect leverage to start to drift up to?

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Robert T. Ladd, Stellus Capital Investment Corporation - Chairman & CEO [10]

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Yes. So it's -- and this would be, Chris, as it relates to our company itself, not portfolio companies?

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [11]

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Yes.

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Robert T. Ladd, Stellus Capital Investment Corporation - Chairman & CEO [12]

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Yes. So I would think of it as, in our targeted leverage from a regulatory calculation would be at 1:1, which we're not at today but certainly achieving to get to 1:1. And then when you include our debentures, certainly the leverage will be higher. So that's the targeted number at this point.

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

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Great. And Rob, are you -- is the coronavirus, the expectation of a slowing economy and all the other factors, is that changing how you are looking to expose -- the industry exposure for Stellus, are you looking to favor certain sectors less than others? How does that affect your thinking?

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

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Yes. So one thing I might mention is that we -- if you go back a couple of years when the tariff discussion was active, we purposely did not invest in a couple of very interesting companies that we thought would be impacted by the tariffs. So we've been mindful of -- since that point of monitoring and limiting exposure or impact from China. But of course, a number of businesses in the United States are ultimately affected because of the supply chain. That may not be their business, but someone they do business with. So as a general matter, we've tried to be certainly cautious in this area. And then as we think about investing now, like we had an opportunity this last week that we reviewed, and it fit, we thought, nicely. And even if there was a larger impact on the U.S. economy, that it would have very little impact on such business. So it's certainly informing our investing at this point. And so I think we certainly would be a little bit more cautious in thinking through how is the business impacted if it becomes more pervasive.

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Operator [15]

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Our next question will come from Ryan Lynch with KBW.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - MD [16]

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I wanted to follow up on the question regarding your leverage. So the 1:1 regulatory leverage is kind of the target you guys have had for a bit, ever since really the 2:1 leverage was approved. And so I'm just wondering, though, in this environment where LIBOR has clearly significantly changed from where you initially set that leverage target, which obviously puts pressure on your portfolio yields and operating earnings, I'm just curious why has there been, I guess, no change to your regulatory leverage target? And also, I know you guys don't provide kind of a total or GAAP leverage target, which would include the SBA debentures. But as -- again, as LIBOR has been heading in the wrong direction and with the Fed cut today it's going to continue that way, do you plan on adding on more total leverage with the SBIC debentures versus -- and still maintain kind of the same regulatory leverage?

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Robert T. Ladd, Stellus Capital Investment Corporation - Chairman & CEO [17]

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Yes, yes. Thank you, Ryan. So as a general matter, on total leverage, I would think of it more in the 2:1 relationship. This would include the SBIC debentures. And so one very positive aspect of our funding base is that under our second license which, as you know, was obtained this past summer, the new debentures are very likely to be lower than the first tranche or the first 150. And that cost, we think, is roughly in the low 3 percentage and may be falling, whereas the first tranche was in the high 3s. So if you think about an ideal source of funding for us today is to begin to fully utilize the second license debentures. So this could cause leverage to get higher through that mechanism.

As it relates to regular way of leverage, the regulatory leverage, we'll certainly look at taking the target above 1:1. I'd say that we would be mindful about state of the economy and we would -- so that's probably the principal concern. And then -- and the -- typically, the regulatory leverage is more governed by your bank facility, where typically this would be true I think for most everyone in the industry, where the covenant for your bank facility would be lower than the 2:1 regulatory cap. So any change, I think, above that 1:1 target would be done in working closely with our bank group, who, by the way, have been very supportive and increased our facility from $180 million to $220 million this past year. So hand-in-hand with them, we could consider a higher targeted leverage.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - MD [18]

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Okay. Yes, that makes sense. Certainly, your outlook on how the U.S. economy is going to fare as well as trying to lease some cushion given your credit facility leverage totally makes sense. I did have one question on the coronavirus as well. So given that this is ever-evolving every day, it's a very fluid situation. It's probably difficult to understand the impacts to your portfolio of companies today and that may be completely different in a week or 2 depending on how this thing spreads. So could you give me some insight as to the process and steps that you guys are taking to monitor your portfolio companies and how they perform? Because the data that they're going to be reporting to you from a financial standpoint is going to be on a lag, and is not really going to show probably the real impact that we're having sort of in real time. So can you just provide some insight as to the process and steps that you're taking to kind of actively manage and understand what's happening in your portfolio companies closer to a real-time perspective?

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Robert T. Ladd, Stellus Capital Investment Corporation - Chairman & CEO [19]

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Sure. And this would be a good -- maybe as a background about our portfolio monitoring generally. So our investment teams are in constant contact with portfolio companies, both management teams and owners. This would be a continuous process throughout each quarter. And then, certainly, at the end of each quarter, we have a full debrief about how the portfolio companies are doing. So think of investment teams constantly being in contact with portfolio company management and their owners.

As it relates to the specific question, we've been reaching out to the portfolio companies who we think could be impacted and receiving -- starting to receive data back. Everyone is evaluating, I think, real-time. So I think certainly by the time we have our first quarter call in early May, we'll have much better information to share with you. So again, I think it's real-time and we have constant dialogue with portfolio companies. So both obtaining and understanding information will not be a challenge.

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Operator [20]

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Thank you. At this time, I am not showing any further questions in the queue. I would like to turn the call back over to Mr. Ladd for closing remarks.

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Robert T. Ladd, Stellus Capital Investment Corporation - Chairman & CEO [21]

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Yes. And one thing I might just add before we close out is Robert's question about LIBOR floors. So I just finalized that while we've been talking. So just of our floating rate exposure, we just have 2 that do not have LIBOR floors. So essentially all do.

Anyway, I think that's it on our end. We thank everyone for their support for our company, just finishing our seventh year, and we look forward to speaking with everyone in early May. Thank you.

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Operator [22]

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This concludes today's call. Thank you for your participation, and you may now disconnect.