Earnings Call Transcript - SCM Q1 2023

Operator, Operator

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 financial results for its fiscal quarter ended March 31, 2023. This conference is being recorded today, May 10, 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 your conference.

Robert Ladd, CEO

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, 2023. 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.

Todd Huskinson, CFO

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 a telephone number and PIN provided in our press release announcing the 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 Ladd, CEO

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.

Todd Huskinson, CFO

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 another quarter of solid earnings. In the first quarter, we more than covered the dividend of $0.40 per share with GAAP net investment income of $0.46 per share. Core net investment income was $0.45 per share, which excludes estimated excise taxes and the reversal of approximately $600,000 of capital gains incentive fees. Net asset value increased $5.1 million due to the issuance of equity under our ATM program and earnings in excess of the dividend of $1.2 million, offset by net unrealized losses on our investment portfolio of $4.2 million. On a per share basis, net asset value for the quarter dropped from $14.02 to $13.87, or $0.15 per share. With that, I'll turn it back over to Rob.

Robert Ladd, CEO

Thank you, Todd. I'd like to cover the following areas: a life-to-date review, portfolio and asset quality, dividends, and then outlook. Since our IPO in November of 2012, we've now invested approximately $2.3 billion in over 180 companies and received approximately $1.4 billion of repayments, while maintaining stable asset quality. We have declared over $223 million of dividends to our investors, which represents $14.15 per share to an investor from our IPO back in November of 2012. Portfolio and asset quality. We ended the quarter with an investment portfolio at fair value of $877 million across 88 portfolio companies, up from $845 million across 85 companies at year-end. During the first quarter, we invested $41 million in 4 new and 2 existing portfolio companies, yet received no full repayments. We did have $6 million of other repayments, which resulted in net portfolio growth of $35 million. At March 31, 99% of our loans were secured and 97% were priced at floating rates, as Todd indicated earlier. We continue to move toward first lien loans. In fact, those are principally the only loans we're making today is unitranche. They were 88% of our home portfolio at quarter end, up slightly from 87% at year-end. We're always focused on diversification. The average loan per company is about $10.8 million, and our largest overall investment is $20.8 million. These numbers are both at fair value. 86 of the 88 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, and 70% of the portfolio is market and investment category 3 or below, which would be below plan. In total, we have four loans on nonaccrual, which comprised 2% of the fair value of the total loan portfolio. Now turning to dividends. As you know, we raised our dividend meaningfully in the first quarter. We continue to cover it as a result of greater earnings that we're generating in this higher interest rate environment. As I said earlier, we're well positioned to benefit from the higher interest rates as our portfolio is 97% floating rate and our liability structure is over 65% fixed rate. Since interest rates have increased again at March 31 for the second quarter, that's when most of our loans reprice, we would expect second quarter earnings to exceed those of the first quarter. 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 years, we've begun to see somewhat regular realized gains in our portfolio. While we did not have any equity realizations during the first quarter, we do expect some during 2023. Now turning to outlook. As a reminder, our platform at Stellus Capital Management includes a number of private institutional funds that co-invest along SCIC, our public company. This additional capital allows us to invest in larger transactions and remain active in the market when our public company may have limited capital and build all portfolios in a diversified manner. Today, total assets under management across the Stellus platform were $2.9 billion. From a macro perspective, the higher interest rate environment, coupled with stress in the regional banking sector, we are approaching the overall economic environment cautiously. Since quarter-end, we have funded $17.1 million at par in 2 new and 6 existing portfolio companies and have received no repayments. This brings our portfolio now to $892 million in 90 portfolio companies. With the additional equity raised since 12/31 that Todd referred to earlier under our ATM program, we expect to grow our investment portfolio to over $900 million this year. For the balance of the quarter, we are starting to see repayments pick up. However, as a result, it is likely that new fundings for the rest of this quarter will be at least offset by repayments. And with that, I'll open it up for questions. Kelly, please begin the question-and-answer session.

Operator, Operator

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

Erik Zwick, Analyst

I wanted to first start, I guess, on the dividend. I'm curious if you can update us on the level of spillover income you have today and just kind of update us on your thoughts in terms of potentially paying a special dividend at some point?

Todd Huskinson, CFO

Yes, Erik, it's Todd. Thanks for your question. Our current spillover income from last year is just over $28 million. The current dividend level in 2023 will be sufficient to cover that spillover. We do not anticipate a special dividend for this year. Looking ahead, while it's possible we could have spillover income and a special dividend next year, we do not expect one this year.

Erik Zwick, Analyst

Got it. That makes sense with the increased base dividend addressing the spillover from last year. Okay, great. Now, switching gears to credit, I have two questions. First, have you seen any rise in amendment requests? Secondly, what is the current sentiment of private equity sponsors? Specifically, if we were to enter a more challenging economic environment, how would you assess their willingness to contribute additional equity if necessary?

Robert Ladd, CEO

Sure, I'll take that one. This is Rob. In terms of additional amendment requests, I would say that we haven't seen an unusual number. Our portfolio remains fluid, but there hasn't been a notable increase in those requests compared to private equity firms. As part of our underwriting process, we evaluate the quality, history, and track record of the private equity firm that owns the business we've financed. We expect them to act responsibly, as they have for over 19 years, and be ready to provide capital when needed. There are times when it may not be economically or reputationally sensible to continue supporting a situation. However, in our experience, private equity sponsors have typically stepped up significantly to address problems.

Erik Zwick, Analyst

Great. And just last one for me. I noticed the PIK income increase in 1Q relative to 4Q. And is that kind of a good run rate to go forward? Or is there anything in the quarter that would not recur in 2Q?

Robert Ladd, CEO

The number is very modest, but we wouldn't expect a material change in that number going forward.

Operator, Operator

Your next question is coming from Paul Johnson with KBW.

Paul Johnson, Analyst

I'm curious if there's some remaining upside in the portfolio, which is encouraging. I'm hoping to get more details regarding the expected net interest income for the next quarter. For the recent quarter, net interest income and return on equity were basically flat compared to the previous quarter, which was surprising given the net growth and the current direction of interest rates. Was there anything that might have caused delays or reductions in those numbers? It seems possible that weaker repayments could be a factor, so any insights would be appreciated.

Robert Ladd, CEO

And Paul, is your question about NII or NAV?

Paul Johnson, Analyst

NII and just kind of the ROE, just I'm looking at roughly like a 12.5% ROE from last quarter is basically flat to this quarter. I just would have expected that to be a little bit higher.

Robert Ladd, CEO

Yes. So I'd say there were some repayments in the fourth quarter that provided key acceleration income. That would probably be the principal difference. And again, as I said earlier, there were no pure repayments in the first quarter.

Paul Johnson, Analyst

I understand. My final question is regarding your comments on equity realizations this year. Are your expectations for additional realizations from some of your equity investments aligned with what you typically anticipate in a given year, or do you have any insight from ongoing discussions and activity within your portfolio?

Robert Ladd, CEO

Sure. Sure. I would say that the comment that I made was just to remind everyone that we do have them. But I would say, just as repayments have slowed, we would expect equity realization to be slowed versus really the last couple of years where they were more robust in '21 and '22. So do we have a line of sight on 2 or 3, but at a reduced pace.

Operator, Operator

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

Christopher Nolan, Analyst

Rob, given your experience, long experience in going through money cycles, what advice are you providing to your portfolio companies in terms of how they can better position themselves financially for the continuation of this current economic cycle?

Robert Ladd, CEO

Well, it probably starts with whether the company is properly capitalized at the beginning and if there’s a need for additional equity capital over time. They have a solid equity capital base, meaning they are not over-leveraged. Additionally, it's important that they have adequate working capital liquidity. This is fundamental, and fortunately, that's how we approach our underwriting. From an operational standpoint, we focus on businesses with significant growth potential but also variable cost structures. This allows them to adapt to changing economic conditions, such as a lower revenue base. That would be my overall advice. One thing that is beneficial in this higher interest rate environment, which seems to have peaked, is that these rates should remain elevated for some time. If they increase significantly, we might see requests for some interest adjustments if rates like SOFR rise to around 7%. We have the flexibility to accommodate such requests, but we haven't reached that point yet. Our view is that interest rates are nearing their peak, so we are not expecting many requests at this time.

Christopher Nolan, Analyst

Great. As a follow-up, are you noticing an increased demand in manufacturing and the type of cash flow lending you provide as offshoring in China begins to return to the U.S.? Are you starting to see that impact your deal flow?

Robert Ladd, CEO

Not in a big way. We certainly have seen some companies reposition away from China, and this has been going down on for now 2 or 3 years in terms of other offshoring locations like Vietnam, but have not seen a big increase in terms of U.S. manufacturing, but it's likely to happen to some extent.

Operator, Operator

There appear to be no further questions in queue at this time. I would now like to turn the floor back over to Rob Ladd for any closing remarks.

Robert Ladd, CEO

Okay. Thank you, Kelly. Again, thanks, everyone, for joining us this morning for our call. We look forward to speaking with you this summer when we report on the second quarter results.

Operator, Operator

Thank you. 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.