Earnings Call Transcript - SCM Q1 2024

Operator, Operator

Good afternoon, 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 financial results for its first fiscal quarter ended March 31, 2024. This conference is being recorded today, May 10, 2024.

Robert Ladd, Chief Executive Officer

Thank you, Kelly, and good morning, everyone, and thank you for joining the call. Welcome to our conference call covering the quarter ended March 31, 2024. Joining me this morning is Todd Huskinson, our Chief Financial Officer, who will cover important information about forward-looking statements.

Todd Huskinson, Chief Financial Officer

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 any 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. Now I'd like to turn the call back over to our Chief Executive Officer, Rob Ladd.

Robert Ladd, Chief Executive Officer

Thank you, Todd. We'll begin this morning by discussing our operating results, followed by a review of the portfolio, including asset quality. I'll then talk about dividends and outlook.

Todd Huskinson, Chief Financial Officer

In the first quarter, we more than covered the dividend of $0.40 per share with GAAP net investment income of $0.42 per share. Core net investment income was $0.44 per share, which excludes estimated excise taxes. Net asset value per share increased $0.15 during the quarter as a result of net unrealized appreciation on our investment portfolio as well as generating NII in excess of the dividend. Life-to-date review. Overall, since our IPO in November 2012, we have invested approximately $2.5 billion in over 190 companies and received approximately $1.6 billion of repayments while maintaining stable asset quality. We've paid over $252 million of dividends to our investors, which represents $15.35 per share to an investor in our IPO in November 2012. Turning to portfolio and asset quality, we concluded the quarter with an investment portfolio valued at $876 million across 94 portfolio companies, an increase from $874 million across 93 companies at the end of December 2023. During the first quarter, we invested $23.8 million in three new portfolio companies and $5.8 million in other investment activities at par. We also received two full repayments totaling $26.2 million and $5 million of other repayments, both at par, which resulted in net portfolio growth of $1.4 million, factoring in net unrealized gains of $3.1 million. As of March 31, 99% of our loans were secured and 98% were priced at floating rates. The average loan per company stands at $9.9 million, with the largest overall investment at $19.5 million, both at fair value. Almost all portfolio companies are supported by a private equity firm. Overall, our asset quality is slightly better than anticipated, with 25% of our portfolio rated at 1, ahead of plan, while 19% is rated at an investment strategy category of 3 or below, indicating it does not meet expectations. Currently, we have four loans on nonaccrual, accounting for 2.1% of the total loan portfolio's fair value.

Robert Ladd, Chief Executive Officer

And with that, I'll turn it back over to Rob to discuss dividends and the overall outlook. Yes. Thank you, Todd. As a reminder, part of our investment 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. Although we did not have any realizations in the first quarter, so far in the second quarter, we have realized one equity position and expect to realize one more, which will mean combined proceeds of about $5.3 million and expected to generate $3.8 million of realized gains and a slight uptick in NAV. And worth noting, the combined multiple of these 2 realizations is just over 3x our original cost basis. At the end of the quarter, we have $60.6 million of equity investments at cost that were marked at $74.9 million. Our historical performance would indicate that the ultimate realization for this portfolio would be greater than 2x our portfolio's cost basis. Of course, however, the ultimate performance of our current equity positions will be dependent on a variety of factors, including, among other things, the economic environment and sponsors' exit strategies. Now about dividends. As you see, we continue to cover our dividend of $0.40 per share per quarter. And to this end, looking forward to Q3 of 2024, we expect, subject to our Board of Directors' approval, to continue our monthly dividend of approximately $0.13 per share, resulting in aggregate dividends of $0.40 per share for the third quarter. And now to outlook. Since quarter end, we have funded $10.9 million in 2 new and 2 existing portfolio companies at par. Additionally, we did receive one repayment of $11.4 million at par and one equity realization previously noted. Proceeds for that were approximately $3 million, which resulted in a realized gain of $2 million. You then combine this activity with our other net funding of about $2.8 million, this brings our total portfolio to approximately $875 million at fair value with 95 portfolio companies. Again, this is as of today. Now looking forward to the balance of the quarter. We are expecting a meaningful increase in fundings and no known loan repayments. As a result, we expect to end the quarter with a portfolio that will be in excess of $925 million; in other words, $50 million higher than where we are today. And with that, I'll open it up for questions. Kelly, if you'd begin the Q&A session, please.

Operator, Operator

Your first question is from Christopher Nolan with Ladenburg Thalmann.

Christopher Nolan, Analyst

Were the realized losses from Numet Machining? It wasn't clear to me.

Robert Ladd, Chief Executive Officer

They were. That was the position that had been marked at 0 for some time and that was the final realization, but no impact on NAV. Chris, are you still there?

Operator, Operator

It looks like Chris has left the queue.

Robert Ladd, Chief Executive Officer

Okay. Why don't we go to our next question and then we can come back to Chris when he comes back on.

Operator, Operator

Okay. There are actually no further questions in queue at this time.

Robert Ladd, Chief Executive Officer

Okay, good. We'll wait just a second. Let's see if Chris comes back.

Operator, Operator

Sure. We do have a question from Bryce Rowe with B. Riley.

Bryce Rowe, Analyst

Rob, I wanted to just kind of ask about market conditions, if you wouldn't mind. You just talked about some good activity here that is expected in the second quarter, especially from here to the end of the quarter. Can you talk about what pricing is looking like? Any kind of dynamic from a competitive perspective that you're seeing with these transactions that would compare to others in the portfolio?

Robert Ladd, Chief Executive Officer

Yes, thank you for joining. As I mentioned in our last earnings call, we anticipated slower activity but expected it to pick up in the latter half of the year. It actually picked up in the second quarter and has continued recently. This is the M&A activity we expected to return, and it has. In terms of competitive dynamics and overall market conditions, all the transactions we're considering are reasonably leveraged, typically 4x or less, and include covenants and equity co-investments as standard practice. The market has experienced a slight decrease in spreads compared to about 3 or 4 months ago when they were in the 6s. We've seen spreads decrease by 50 basis points or a bit more over time. Beyond that, there's been a significant increase in activity. I also wanted to mention that we've had some equity gains, with one already realized and another expected this quarter, which could extend into the first month of the following quarter. Additionally, we've learned about a few more potential gains that could come in the fourth quarter. This suggests that M&A activity is increasing on both the new deal front and within our existing portfolio, leading to greater gains for us later in the year.

Bryce Rowe, Analyst

Okay. And Rob, when you think about it, you just said that some of the activity got pulled forward from what you thought to be second half to second quarter. Is there still a pretty active pipeline beyond what you see here coming in the second half or the second quarter?

Robert Ladd, Chief Executive Officer

Yes. So wouldn't expect anything to change there for the balance of the year. It's picked up meaningfully.

Bryce Rowe, Analyst

Okay. And then when we think about funding the new activity, how should we think about that? I mean obviously, you have some room on your credit facility. And I guess with the benefit of visibility here towards what can close in the back half of this quarter, how do you think about using equity versus debt to fund that?

Robert Ladd, Chief Executive Officer

Yes. I would say that compared to equity, our stock price has improved somewhat. As we were involved with our ATM program last year, we will certainly consider it again this year, primarily driven by our pipeline. However, it's more likely that we will approach it in this manner rather than through a larger offering. So, think of the ATM as a tool we would utilize this year. Overall, from a leverage standpoint, as you mentioned, we have significant capacity in our bank facility and a considerable amount of cash from repayments in our SBIC entities. For instance, we have plenty of capacity to exceed the $925 million I previously mentioned, and certainly surpass $950 million or more. I believe we are in a solid position. Overall, our capital situation is strong, and we may see some activity in the ATM.

Bryce Rowe, Analyst

Okay. Last one for me just in terms of kind of internal risk ratings, there was some movement from the December quarter to the March quarter. It looks like Category 3 bumped up a bit. Can you talk a little bit about kind of the dynamic driving that?

Robert Ladd, Chief Executive Officer

Yes. Looking at the changes, I'd say it reflects a normal evolution in the portfolio over time. There is nothing overly concerning. A loan investment would be classified as nonaccrual at a rating of 4, while a rating of 3 indicates it's operating below plan. We also had some upgrades, which are typical as well. A couple of positions improved to a rating of 1 and a 3 moved to a 2. Overall, it's not worrisome. When we consider the entire portfolio, our average weighted risk rating, as Todd mentioned, is just under 2, which indicates it's performing better than planned.

Operator, Operator

Your next question is coming from Erik Zwick with Hovde Group.

Erik Zwick, Analyst

Wanted to start a little bit on in terms of your comments about so far in the second quarter, not seeing any repayments from a number of the other BDCs that have reported this quarter. Repayment activity has been pretty high. I know it's tough to have a certain high degree of certainty in your outlook over probably the next couple of months or so. But do you think there's something inherent in your portfolio that's resulting in lower repayments there? Is this just kind of maybe a temporary lull here that we're seeing this quarter?

Robert Ladd, Chief Executive Officer

Yes. I think it's that, Erik. It's certainly ebbs and flows. But as I mentioned, we've recently learned about a couple of companies that are going to come to market in the third and fourth quarter. And they would result, in addition to an equity gain, would result in some good repayments. So I think we've just gotten to a little bit of a low point here.

Erik Zwick, Analyst

I understand. That makes sense. My only other question is whether, given that base rates have remained high for a while and seem stable with no immediate likelihood of reducing significantly, you have had any opportunity to increase the floors while underwriting loans or in negotiations, or are they still at the same levels we've experienced over the past several years?

Robert Ladd, Chief Executive Officer

Yes. So we've always been focused on floors. And generally, they vary between 1% and 2%, and think of us as being closer to 2%.

Operator, Operator

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

Christopher Nolan, Analyst

I'm back, and my phone is working now. You have some SBA loan maturities coming up next year and beyond. The amount maturing in 2025 is around $12 million, but it starts to increase after that. Currently, the cost of that debt is quite low. What are your options? Can you refinance with the SBA to get low-cost funding again, or will you need to seek refinancing through a bank facility?

Robert Ladd, Chief Executive Officer

Yes, that's a good question. We hold two SBIC licenses, and the first one will start maturing in March of next year, with additional maturities occurring over several years. Currently, we are applying for a third license. This is a normal progression in the SBA process. Many of the existing debentures were issued in a lower interest rate environment, as you noted. They are priced based on the 10-year treasury plus a market premium, usually below 1%. If conditions remain unchanged by next year, our borrowing costs from the SBA will likely increase. The 10-year treasury was recently below 4.5%, so with the premium, we anticipate rates in the 5% range. This is still quite favorable compared to typical bond offerings of similar duration, which are in the 8% range or higher. Thus, while our costs will rise, they will still be very competitive.

Christopher Nolan, Analyst

I have a strategy question. I've noticed that while you had a management fee waiver this quarter and also last quarter, your leverage is quite low. I'm curious as to why you haven't increased your leverage a bit more, especially since your earnings appear to be solid.

Robert Ladd, Chief Executive Officer

Yes, I think you are referring to an incentive fee waiver rather than a management fee waiver, and this is related to our 12-quarter test. Not all BDCs use this test, but we look back at historical performance over 12 quarters. We did have a small waiver in the first quarter and may have a bit more this year, but that's just part of that test.

Operator, Operator

There are no additional questions in queue at this time. I would now like to turn the floor back over to Mr. Robert Ladd for any closing remarks.

Robert Ladd, Chief Executive Officer

Okay, yes. Thank you, Kelly, and thanks, again, everyone, for being on. Thank you for your support, and we look forward to reporting the second quarter in August. Take care. Enjoy the summer.

Operator, Operator

Thank you, everyone. This does conclude today's conference call. You may disconnect your phone lines at this time, and have a wonderful day. Thank you for your participation.