Stellus Capital Investment Corp Q3 FY2020 Earnings Call

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 third quarter 2020 results conference call. This conference is being recorded today, Friday, October 30, 2020.

Okay. Thank you, Ryan, and good morning, everyone. Thank you for joining the call. Welcome to our conference call covering the quarter ended September 30, 2020. Joining me this morning is Todd Huskinson, our Chief Financial Officer, who will cover important information about forward-looking statements and then later, an overview of our financial information.

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, Robert Ladd.

Okay. Thank you, Todd. At the outset, I'd just say having now gone through two plus quarters of the impact of COVID-19, I'm glad to report our portfolio is stable, and all borrowers on accrual have made their scheduled principal and interest payments for the third quarter. I will discuss the portfolio, including asset quality in more detail shortly, as well as an outlook and also the dividend status. First, Todd will cover our operating results for the quarter.

Thank you, Rob. From an operations standpoint, we generated net investment income of $0.27 per share, which more than covered our regular third quarter distribution of $0.25 per share. Core net investment income which includes taxes for the third quarter was $0.29 per share. In addition, valuation on our portfolio increased by approximately $2.1 million or $0.11 per share, and this, along with realized gains of $0.01 per share, resulted in total earnings for the quarter of $0.39 per share. Normally, we would have declared a single quarterly distribution of $0.25 per share, which would have resulted in a $0.14 per share increase in net asset value for the quarter from $13.34 to $13.48. However, to complete the distribution of spillover income from 2019 in a timely manner, consistent with maintaining our qualification for taxation as a regulated investment company and to eliminate our liability for corporate level U.S. federal income tax, we are required to declare an additional $0.31 per share of distributions by September 15. As a result, net asset value declined to $13.17 per share at the end of the quarter. I'd like to note that these distributions constitute all remaining distributions for the year. So our fourth quarter net asset value will not be further reduced by distributions paid in the fourth quarter. And with that, I'll turn it back over to Rob.

Okay. Thank you very much, Todd. I'd like to now cover the following areas: our portfolio and asset quality, liquidity, and outlook for the balance of the quarter, and then discuss dividends. With respect to portfolio and asset quality, again, I'm pleased to report that most of our portfolio companies' operations are stable and managing well in the current environment. Overall, our asset quality is stable at a 2 on our 1 to 5 investment rating system or effectively on plan. Ninety percent of our portfolio is rated at 2 or better or on plan or better. Therefore, ten percent of the portfolio is rated at 3 or below, which is below plan. Nonaccrual loans comprise only 1.5% of the fair value of the total loan portfolio, and no loans have been added to nonaccrual status since April 1. We continue to make good diversification with the largest industry sector at 18% of the total at fair value. As of September 30, the average investment per company is about $9.4 million, and our largest investment is $21.6 million, both numbers at fair value, and 62 of the 66 portfolio companies are backed by private equity firms. We are seeing interesting opportunities as the world has become a little clearer, and we're beginning to invest selectively. During the third quarter, we made investments in two new and three existing portfolio companies, which totaled about $19 million. We also received repayments of $40 million, including four full repayments and several partial repayments, a number of which were revolver repayments. As a result, we ended the quarter with an investment portfolio at fair value of $622.4 million in 66 portfolio companies, down from $641 million at June 30. From a capital management standpoint, working closely with our bank group, we extended the revolving period of our $230 million bank facility from March 2021, all the way to September 2024, with a final maturity of September 18, 2025. Additionally, we amended certain covenants and conditions of the facility, including an increase in the maximum allowable leverage to 1.5:1. As of today, our remaining unfunded commitments are approximately $31 million, and we have cash and revolver capacity of approximately $63 million, and this excludes cash and debenture availability at our SBIC subsidiaries. At the SBIC subsidiary level, we have investing capacity for new investments from cash and/or debentures that are approximately $40 million. This brings liquidity overall and meaningful capacity to make new investments. For the balance of the fourth quarter, we estimate that we'll have new investments at least equal to the amount of repayments and equity realizations, we think that number could be as much as $30 million. If it's helpful, we think that these repayments and realizations, if they occur, would have a positive impact on NAV over the September 30. I'd like to conclude this morning's call by covering dividends. As a reminder, we declared a regular dividend in September for the fourth quarter of $0.25 per share and a special dividend of $0.06 per share, both payable at the end of December. This brings total declared dividends in 2020 to $1.15 per share and brings life-to-date declared dividends to $10.91 per share. Subject to approval by our Board, we expect to be back to you regarding the first quarter dividend of 2021 by mid-January, which would return us to our normal timing for declaring dividends, in other words, in the first month of the quarter.

And with that, I'll open it up for questions. Thank you. Ryan, you may open up the Q&A session.

Rob and Todd, maybe first, I can start on the liquidity profile. Todd, just curious how much cash is sitting in the SBIC right now, and was wondering if you possibly anticipate drawing debentures to fund some of this potential activity in the fourth quarter.

Sure. Thank you, Bryce. So we have roughly $25 million today of cash in SBIC 1. We have two licenses. We have a lot of cash in SBIC 1 that we would expect to use to recycle into new investments. In SBIC 2, we've got the ability to draw debentures there as well. The way to think about it is the pipeline, as Rob mentioned, is full, and we have a lot of interesting opportunities, a number of which are SBIC qualifying. I think we would use a combination of both the cash that's in SBIC 1 as well as drawing debentures in SBIC 2 to fund that activity.

That's great info. And then I wanted to -- maybe, Rob, we've talked about this in the past. But maybe get your updated thoughts around it. So you obviously had the good fortune to amend and extend the credit facility here in the most recent quarter. One of those amendments included the requirement by that bank group to have the 2022 baby bonds redeemed by March of 2022, ahead of their maturity later in the year of 2022. So I'm just kind of curious how you're thinking about the potential redemption of those bonds. I know we're still a good year plus away from needing to do that. But potentially, the market is open to some type of activity that would allow you to redeem and maybe upsize to create more of a capital structure that is more heavily weighted towards that unsecured type of debt.

Sure, Bryce. Yes. As a reminder, we have $49 million of unsecured notes that mature in September of '22. So there's 18 months left, two years left, but 18 months left and pursuant to the bank requirement. As I said earlier in the year, one of our goals in the second half of 2020 would be to possibly have a new fixed income offering. We've been patient. A number of companies raised unsecured notes at much higher coupons than you could do today. Fortunately, that's paid off so far. We haven't quite gotten there, but we're getting closer. I would think over the next 90 days or so, we'll certainly be looking at it. We have meaningful liquidity as indicated earlier, roughly $63 million of liquidity, including our unused remaining facility on our bank credit agreement. We want to be patient about this, so it may be that this moves into 2021 as an event, but we'll certainly take care of this in advance of the March '22 date through a combination of new offerings and meaningful liquidity we've developed. Don't expect any difficulty in being able to do that.

Rob, I noticed that on a fair value basis, the portfolio is increasingly favoring first lien debt, lower second lien debt. Is that a trend that we should see continuing going forward? Or is it just sort of opportunistic?

Yes. Thank you, Chris. This has been a rotation that we've now been working on over the last two to two and a half years. So you should expect it to continue. It would be unlikely we participate in any mezzanine financing. We are looking at some second liens where we think they have the right capital structure and owner. The vast majority of our investing at this point will be first lien unitranche debt, and hopefully, we always try to purchase a small piece of equity at the same time. So that's going to comprise most of the portfolio going forward.

And then my follow-up question is actually for Todd. The interest income was slightly up quarter-over-quarter, but the portfolio of investment volumes were down, and the yields seem to be flat. What was driving the -- I would think the interest income would have gone down with all of that but stayed relatively steady. I'm just trying to see why.

Yes. Chris, I don't know that there's a specific reason other than fee income. We had a number of payoffs in the quarter, as Rob mentioned, and had some additional fee income. Some of that fee income is included up in the interest income line item as well. So that's likely what's driving it.

Congratulations on the quarter. First, maybe for Todd and then a question for you, Rob. Based on where you stand today on estimated spillover going into 2021. Can you give us any color on your dividend for 2020, the taxes, which was essentially driven by having to distribute spillover? What's the minimum distribution requirement for 2021 as spillover stands today? Is that consistent with the covenants based dividend, if not, what discussions have been had as to how you want to handle that?

Yes. Thank you, Robert. One of the things I will tell you and the groups that we've learned is it's difficult to predict spillover income until the end of the year, of course. I would expect there still to be meaningful spillover income from 2020 into 2021, maybe not quite as much as the current year. I still think there's meaningful income spilled over to '21. I'm not sure if the current dividends, the normal dividends would cover it, or if there would need to be something special; I just don't know that.

Okay. That's your point. It is hard to predict almost a year. So Rob, on the market, right, obviously, you're talking about the activity. What are you seeing in terms of, if you can, quality deals, terms, pricing? What industries are making up more of your phone call, the incoming, not necessarily ones you consider, but can you give us any color about between different industries that are coming up? Do the terms vary considerably by industry type succession? Any color would be very helpful.

Sure, Robert. As I said earlier, we're seeing a number of interesting opportunities. We've always been very selective in our investing and continue, probably even more selective than ever. What we found are those businesses that are business-to-business continue to do well. As a result, most of our portfolio continues to do well. Companies we're seeing, part of this flow we're seeing are those doing well during COVID-19 related to social media and other aspects of technology and applications. A great deal of activity -- our pipeline is over 10 companies that we're looking at today in various stages of diligence. Businesses that have done well throughout the COVID period are expected to do well, knowing that the COVID pandemic impact is not over. The private equity world is very active, and we operate in the lower middle market, which would have an average EBITDA of probably between $10 million and $20 million. The quality of the transactions we're looking at are excellent in terms of the capital structures. The minimum equity check in a company would be at least 40% of the capitalization, and more typically, 50%. The capitalization structures continue to be good and strong. We're only involved in transactions that have meaningful covenants. Pricing did increase during the summer months, but we're getting pretty close now to attractive opportunities that are really close to pre-COVID levels. It could be some slight margin improvement, but closer to pre-COVID levels than not. We're encouraged, and this shift reflects the nation's economy generally, and some industries and sectors are doing relatively well during this difficult time. This is a meaningful change from July as the world is becoming clearer to people. Activity is likely to increase due to tax reasons, so we're seeing some businesses likely to be sold and closed by the end of the year where people can lock in what they think is the capital gains tax rate.

I appreciate that color. I want to try to follow up on that. Of those 10, depending on the election result, which hopefully, we'll know next week, could some -- if it goes one way, capital gains taxes might not change it because the other way there could be a change. Is some of that pipeline contingent on an election result? Or once the process has begun, are people just more likely to go through it? Or is there some risk of volatility depending on what happens next week?

Yes. I would say that one, it's not the majority of the transactions, but I expect they would close regardless of the outcome of the election.

I wanted to follow up on some of Robert's questions regarding the pipeline you guys are seeing. I know you mentioned you're starting to see a big increase in opportunities. But can you clarify, are opportunities in the pipeline that you guys are seeing just a big increase from what you were seeing this summer, which had very little deal activity? Or are you starting to see a pipeline in opportunities more similar to what we saw pre-COVID?

Ryan, it's a good question. I would say pre-COVID. It’s hard to tease out; it might be the desire to get something closed at the end of the year skewing it a bit. But there are several businesses and sectors in the country doing well and private equity funds. A requisite too and some would be adding to an existing platform. Certainly, our pipeline is about as good as it's been in some time. This could also be the impact of somewhat of pent-up demand from people who had not been investing since the March to September period. So our pipeline is approaching much more normalcy compared to where we were pre-COVID in terms of activity. I'd say a few things. We're as selective as we've ever been, more selective than even normal, given the uncertainty in the country. But through that even more refined lens, we're finding several interesting opportunities with good private equity firms who are good owners of these businesses. Our underwriting philosophy has been to consider any company for the potential of a recession. We're underwriting companies as if there is a recession, and evaluating how they performed historically or their sector through past recessions. We occasionally look at cyclical businesses entering them at low leverage regardless of when we enter or evaluate these businesses carefully. We are seeing nice interesting companies with good owners and management teams, a track record due to COVID. We remain cautious about how much of the business performance is tied directly to COVID and what the effect might be after COVID.

At this time, there are no further questions. I will now turn the conference back over to Mr. Ladd for any closing remarks.

Okay. Thank you. Thank you, everyone, for your support and listening in today, and we look forward to speaking with you in the spring. We expect to be back to you in January with more news about the dividends for next year.

Thank you, ladies and gentlemen. This concludes today's conference. All participants may now disconnect.