Stellus Capital Investment Corp Q4 FY2022 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'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.

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.

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.

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.

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.

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% 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?

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

First, I just wanted to get your thoughts a little bit on the new dividend level at $0.40 a share. I'm just curious. The interest rate environment continues to go up, and that will likely be 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.

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.

And switching gears to credit. As you pointed out, nonaccrual is still 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 business activity weakening for any of your borrowers? And also are you experiencing any increase in amendment requests at this point?

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?

Just if you've seen any increase in amendment requests from any portfolio companies.

We have not. One thing I can share is that as rates continue to rise, there may come a point where some stress could be experienced by portfolio companies, but we believe we still have a good ways to go before higher rates will have an impact.

And then last one 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?

Yes. So I'll turn that over to Todd.

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 the $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.

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.

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

Congratulations on the quarter. Regarding your earlier comments, Todd and Rob, you've mentioned before about earning the dividend from realized income, and that it can also be achieved from pure net investment income in the short term. Rob, you indicated that equity gains are likely to slow this year, which seems to be part of the cycle. Do you expect them to remain slow for the entire year? Or is there a factor related to age vintages that would suggest they could remain slow for more than a year before picking up again later? Any insight you could provide on this would be helpful. Additionally, I’m eager to hear more from you.

Sure, that's a good question, Robert. I want to clarify that as we review each quarter's activities, we notice that while we've had a lot of indicators in previous quarters, right now, there isn't a lot on the horizon. However, we've learned that this can change. It's not a specific problem; rather, it's more about the general state of the M&A market, which we anticipate will be slower. Additionally, it seems that repayments have also slowed for now, but I wouldn't consider this a long-term trend. It's likely that we'll see an increase in activity as we move into the middle of the year.

Got it. Conceptually, in the long term, how much of your total realized earnings do you expect to come from net interest income compared to realized gains on average?

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

Going forward, how much should we expect to come from net interest income compared to the realized gains? Both generate value and contribute to dividend funding, but I'm just trying to understand the balance.

Sure. I'd say for the foreseeable future, again, based on the forward curve, which has now risen up 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.

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.

Understood. To that point, your realized gains have consistently outpaced your realized losses, which supports your dividend funding as well. What are you currently observing in the environment? You mentioned that you anticipate the portfolio to stabilize at around $850 million to $900 million this year, particularly in the first quarter. Is this simply a year of rotation with some repayments and additions, or do you foresee a more significant rotation in the second half? Can you provide any insights on how you expect the year to unfold in terms of your activity levels?

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.

Our next question is coming from Ryan Lynch with KBW.

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

Yes. The number of companies is at 83 out of 85, which is over 95%.

Okay. Sorry, I missed that if you said that earlier.

No worries.

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.

Certainly. Let me address this first and see if Todd wants to add anything. The fourth quarter was somewhat unusual due to some fee acceleration. Additionally, as Todd mentioned earlier, the net interest income was influenced by the reversal of certain capital gains incentive fees. I would expect that in the first quarter, we will have net interest income that is less than $0.50 on a GAAP basis, but still above the dividend. In terms of core net interest income, we are likely to see an increase compared to the previous quarter due to the higher rates. To clarify, we anticipate that our earnings will be greater in the first quarter compared to the fourth, and even more so in the second quarter, as rates have risen further. At the end of the fourth quarter, LIBOR was around 3.75, while at the end of the first quarter it was closer to 4.75, and we expect LIBOR to exceed 5 when we enter the second quarter. We will also see some repricing during the quarter since some are on monthly pay and adjust monthly. However, it's important to consider the quarter-over-quarter changes in other factors. To summarize, we expect our earnings to increase in the first quarter compared to the fourth, and in the second quarter compared to the first.

What was the level of accelerated fees in the fourth quarter compared to what you anticipated? I know it can vary, but could you share an average run rate that you would expect to see?

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.

Yes, that's right.

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?

So, Ryan, we haven't really focused on that. The reason is that the leverage that enables us to increase from the low 1s to the low 2s comes from the SBIC debentures. Our shareholders are reaping the benefits of our two licenses with the SBA and the lower funding costs we've secured over time. If we were considering non-SBA leverage that had different terms and shorter maturities, that would certainly be a factor. However, we believe this is the appropriate leverage. So, think of it as 1:1 without the debentures and a little over 2:1 with them. We feel this is the best way to operate and truly reward our shareholders for their long-term support, especially in this favorable interest rate environment.

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 – having an influence. So it sounds like you’re more in that latter camp.

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.

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

Rob, could you expand on Ryan's question a little bit? What is your broader economic view right now that guides your investment decisions?

Overall, we believe the economy is facing some challenges, but these have not significantly altered the broader economic landscape. Inflation is a concern and has shown some volatility on a monthly basis. We remain cautious, yet we do not anticipate any major downturn in the near future. The primary factor that may affect the economy and our portfolios is the potential for rising interest rates. For instance, if the SOFR rate were to rise from the current high 4s to the high 6s or 7s, that would have a significant impact. However, at the current rate, our portfolio can manage higher rates, especially within a range of 100 to 200 basis points. Therefore, we are cautious but optimistic, and we plan to remain quite active throughout the year.

Given the current inverted yield curve and the changing interest rate environment, do you foresee any situation where you might become more sensitive to liabilities? Are you anticipating the peak of the interest rate tightening cycle and the beginning of an easing cycle? If so, would you implement measures, such as hedges, to protect your margins in a declining interest rate environment?

It's a good thought, Chris. We've chosen to go with the flow of the market over time. One option could be to lock in some of our loans at fixed rates with borrowers at higher rates. This is one possibility to consider, though whether our borrowers would find it appealing is another question. We prefer to benefit from the market dynamics we encounter. While we would consider this option, I see us more as a firm that does not engage in interest rate hedging.

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

It seems that the expansion of rates will conclude this year. We have learned to follow the forward curve. I remember, Todd, that it expands into the third quarter and starts to flatten in either the third or fourth quarter of this year.

Yes.

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.

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.

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.

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.