Stellus Capital Investment Corporation (SCM) Q3 2018 Earnings Report, Transcript and Summary

At this time, I would like to welcome everyone to Stellus Capital Investment Corporation’s conference call to report Third Quarter 2018 Results. [Operator Instructions] This conference is being recorded today, Wednesday, November 7, 2018. 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.

Thank you, Cassidy. Good morning, everyone and thank you for joining the call. Welcome to our conference call covering the third quarter ended September 30, 2018. 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 would 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 would also like to call your attention to the customary Safe Harbor disclosure in our press release regarding the 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 SEC filing 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 would like to turn the call back over to our Chief Executive Officer, Rob Ladd.

Yes. We will begin by discussing our operating results followed by a review of the portfolio, including asset quality and then the outlook. And Todd will start with our operating results.

Thank you, Rob. We had a good quarter and continue to have a good year. We cover our quarter third quarter distributions through GAAP NII of $0.35 per share, core NII per share, which excludes the capital gains and incentive fee accrual was $0.39 per share. Our growth in NII in the third quarter was driven by higher interest income and approximately $900,000 of fee income related to repayments. We also generated a realized gain of $2.8 million or $0.17 per share resulting in realized income on a GAAP basis of $0.52 per share. Finally, net asset value increased $0.22 per share during the quarter from $14.07 to $14.29 due primarily to unrealized appreciation of our investment portfolio. Life-to-date through September 30, 2018, on a combined basis, we have generated net gains both realized and unrealized of $5.9 million. And with that, I will turn it back over to Rob to discuss the portfolio and our outlook.

Yes. Thank you, Todd. With respect to portfolio, we ended the quarter with portfolio at fair value at $478 million across 53 portfolio companies. During the quarter, we made $32 million of new investments at par, three of these were new and three were existing portfolio companies. The three new investments totaled $26.8 million at par. All are first lien and have a weighted average yield of a little over 9% all of the loans are at floating rates. We had five repayments totaling $51.9 million and $5.1 million of amortization and other repayments. In terms of asset quality, it is stable at a 1.9% on our investment rating system or slightly better than planned. 21% of our portfolio is rated 1 or ahead of plan and only 10% of the portfolio is marked at investment category of 3 or below. In total, we have three loans on non-accrual, which are $5.9 million combined comprising 1.3% of fair value of the total loan portfolio and there were no additions of non-accruals in the quarter. We continue to maintain good diversification with the largest industry sector at 13% of the total. The average investment per company is still $9 million and the largest investment is $29 million, which are both at fair value. Since quarter end, we sold the $29 million position down to $19 million, so our largest position now is $22.2 million. Finally, our portfolio continues to be weighted towards secured lending at floating rates. At September 30, 95% of our loans were secured and 90% were at floating rates. Also, 50 of the 53 portfolio companies mentioned previously are backed by private equity firms. I would like to take a moment now to comment on our portfolio construction. As noted earlier, we have been shifting the investment portfolio to a more secured status and floating rate pricing. Further, we are increasing the percentage of unitranche of first lien. As of quarter end, the percentage of first lien was 54%, which is up from 38% just 9 months ago. Along with this lower risk position in comes the lower yield, of course. To illustrate, the loans paid off in Q3 had an average yield of 11.6% and the new loans funded were approximately 9.1% and somewhat offsetting these lower notional yields is the likelihood that interest rates will continue to rise, especially LIBOR. In just the past 37 days, the 90-day LIBOR has increased about 21 basis points. As a reminder, 90% of the portfolio is at floating rates and our only floating rate liability is the bank facility. Also worth noting in our portfolio construction are the equity co-investments. Although a small percentage of the portfolio approximately 7% at 9/30, the equity investments have generated $5.2 million of realized gains or $0.32 per share this year. Now, turning to the outlook, since the third quarter, we have had a small realized gain on one equity position of approximately $300,000. We funded $24.4 million at par in two new and one existing portfolio companies. Additionally, we have received $25 million in full repayments on two portfolio companies and a partial sale of our largest investment as previously noted. For the balance of the quarter, we are expecting new investments of approximately $25 million to $35 million and repayments of $10 million to $15 million, which mean the portfolio at year end, should be between $480 million and $500 million. Lastly, as a reminder, we have approval to achieve higher leverage than 1:1, which was obtained at our shareholders meeting in June. We upsized our bank facility in August, which I previously reported on which will allow us to grow the portfolio to up to $600 million from $478 million currently, which is of course our goal for 2019. With that, I will open it up for questions and thank you. And Cassidy, please begin the Q&A session.

Thank you. [Operator Instructions] Our first question comes from Robert Dodd of Raymond James.

Hi, guys. On your comment you just made of an increasing percentage of unitranche, there is a couple attached to this question. What would you say that you are seeing in the market today in terms of terms and structures on pure traditional first lien maybe versus unitranche in terms of how that’s evolving with the market being as competitive as it is?

So the unitranche structures, of course, attractive to the owners, private equity sponsors, mostly in our case, because it’s effectively a one stop shopping and you accomplish all the financing in one vehicle. So, we think that’s certainly what’s driving part of this and it simplifies the closing transaction and probably simplifies the ongoing activity. So, we think it’s becoming more commonplace. We like the structures. And then with respect to pure first lien, the leverage quotient for a pure first lien might be in the range of 2x to 3x, whereas the total unitranche could comprise a leverage of 4 perhaps all in.

Okay, got it. Appreciate that. And then how does this – I want to call it a change in strategy let’s say, but a little bit of a change in mix and the lower yields on the unitranche, I know you mentioned another one. Is that all that in the forward demand into ‘19? Obviously, you want to play with portfolio, you increased the leverage a little bit. Are those two intrinsically related or would you be doing this rotation a little bit to more first lien, low yield even if the capital structure side of the BDC remains the same, I remember it’s been 1:1, I mean how intrinsically are those you think tied together?

Yes. So, great question, Robert. I would say that this is a movement that you can tell from a portfolio standpoint. It’s been going on for some time both first to secure and then second to more first lien versus second lien. So, I think it’s strategically a path we have been on. There is no question that we are helped by having some incrementally greater leverage to have lower yields, but I think it’s just – I think it’s what we will be doing anyway. And again, we are helped of course by having some additional leverage and as I have shared with you before or shared with our investors before, we are now targeting to get to a 1:1 leverage much higher than that versus where we have been operating at like 0.7 to 0.8 to 1.

Got it, got it. And then one more if I can. You mentioned obviously equity is about 7% of the portfolio. The rest of the portfolio is shifting more and more to very much secured. There is obviously another component that you could utilize, which would be the 30% bucket, 30% bucket can still be secured investments. But any color on what can – do you actually expect to utilize a bit material portion of that 30% bucket for things other than that, the same kind of assets you are doing right now or is that just something that’s maybe on the cards long-term, but not priority to add anything different from that front?

Yes, so again a very good question. So, we certainly over time have been looking at other ways to add products in the company. So one example, you have seen asset-based lending, subsidiaries, leasing type subsidiaries. So, we certainly thought about those. There is nothing imminent though. I think for the near-term, I expect that our investing will continue to look like it has with – again we are primarily financing the acquisition by a series private equity firm of a private business. And along that, we have, as part of our strategy to participate in modest ways of buying equity co-investments effectively at par at closing. So I think that for the moment is certainly the primary strategy, but we will certainly look at things over time and you are good to raise that we do have the possibility to have dropdown subsidiaries that could be enhancing into pacifying, but nothing imminent on that front.

Got it. Thank you. And congrats on the quarter.

Yes. Thank you, Robert.

Our next question comes from Paul Johnson of KBW.

Hi, guys. Good morning. Thanks for taking my questions. Congratulations on a good quarter. First, I am just looking at your interest income debt portfolio shrank a little bit this quarter. I am wondering was that driven mostly by prepayments this quarter and should we expect that kind of come down to maybe a more normalized level?

Yes, so thank you. Thanks for joining. So, we are a little bit lower at quarter end than we thought we would be. We had an unexpected repayment or two. And also we have been – we might have been higher, but we have been very selective in our investing and like we had one investment that we thought would be material impacted by what’s happening in China and declined to participate, so a little bit lower than we thought would be for the quarter. It looks like we will be close to flat or little bit up for the fourth quarter, but we continue to see interesting opportunities and we would expect to be able to grow the portfolio on a net basis certainly in 2019.

Sure. And kind of getting more to the interest income this quarter, it beat us by a pretty good margin and was little bit more than we were expecting. I am just wondering, I mean was that driven by more of the prepayment fee income from the repayments during the quarter?

Yes, Paul. This is Todd. So, the interest income, just the base interest income was higher than last quarter just because of a larger portfolio during the quarter, but we did have some significant payoffs during the quarter. And so we had what I will call, it’s non-recurring only that it doesn’t happen every quarter about $900,000 of income related to repayments and $300,000 of it was prepayment income, which is down in other income, but about $600,000 of it was up in interest income in that line, which is just the re-class of fees as well as pay-offs. So that’s all tied to repayments. However so far this quarter, we have visibility into about $500,000 combined of that type of income both the fee and the interest income and it could be more depending on what repayments happen.

Yes. Paul, just to add what Todd said that I think part of this is an addition to the fee income is that the portfolio was of a decent size during the quarter, but happened to be lower by quarter end.

Sure. Okay, yes and I understand. Thanks for clearing that up. And then finally, my last question has to do with your SBA funding, I believe earlier in the year as a part of the small business investment acts, they increased the maximum borrowings under a license, $175 million to $150 million. I am wondering does that – first off, does that apply retroactively to your current licenses that you have today? And I guess if it does not hurt you in the process of trying to slip out a second SBA license?

Yes. Paul, this is Todd again. So, it is not retroactive and I believe we announced last time that we are in the process of working through with the SBA license on another license and can kind of report on that as we go forward.

Those are all my questions. Thanks for taking them today.

Yes. Thank you, Paul.

Our next question comes from Owen Lau of Oppenheimer & Company.

Good morning. Thank you for taking my questions and congratulations on the strong quarter. For Wise Holding, it was a non-accrual loan in second quarter and may have high conviction in this company, but could you please add more color on the why put in addition of $300,000 in the first lien related to long-term loans when you also marked on the loan like $300,000 in the third quarter?

Sure, yes. Thank you for joining the call. So, this is a small position that we have. We also are careful not to talk too much about private businesses that have operations that they are conducting, but this was the case where given our position in the credit, we needed to further support the company to give it more time to realize full value. So, that was the reason for some increased funding. This is rarely done in our case, but we thought it was warranted at the time and we will be watching the credit from here.

Got it. Okay, that’s good. And another question about Good Source Solution, I am not sure how much you can talk about that, but you invest in this loan in the second quarter and you also have mentioned that it was a big position and you would also get the size into a smaller piece over time. And you sold a piece when I look at the press release you sold a piece in October. Maybe just please talk about the developments in second quarter to October and your intention to keep the rest of this company. I know you know this company a long time and any intentions to continue to sell it down? Thank you.

Yes. So with respect to that portfolio company, we did have maybe coincidentally I guess, we had a question last quarter about it was outside of our normal range of investing and so sometimes we will be involved in funding a credit to be helpful to the owner sponsor, but with the intention to have the size be lower over time. Usually, we are able to accomplish that by closing, in some cases it’s beyond closing, which was the case here. And so we were able to accomplish that within roughly 90 days of closing, so positive about the company. It was just literally a risk sizing issue. We would like to kept as if we could, but again we try to have our largest positions be in the low 20s and ideally in the teens.

Okay, got it. Thank you very much. That’s it for me.

Yes, thank you.

The next question comes from Christopher Nolan of Ladenburg Thalmann.

Hey, guys. Sorry for joining the call late. I take it that your previous target range of $525 million to $540 million by year end is off?

Yes. We are targeting as you may have missed the prepared remarks, we are targeting a range between $480 million and $500 million by this end of calendar year.

Great. And Rob, in your comments when you mentioned that you ae going to be increasing leverage eventually reaching 1:1, do you have any idea of when you might be able to reach 1:1. Right now, your debt leverage seemed to show a lot of room?

Yes, yes. So the rough math is, with the increased credit facility with our banker that we closed in August, we now have $180 million facility. It’s subject to a borrowing base and there is roughly $100 million, more than $100 million of room in the facility currently. So even if you fast-forward and increasing the portfolio to $600 million, which is our goal for next year that would get us to right at 1:1.

Great. Final question, are there any particular industry sectors that would help you propel the portfolios of that size?

We are open minded about industry sectors but I would say that we – I would say the one governing factor is always being mindful of not being overly concentrated in any one. And as you may have heard us say before, we try to keep the largest sector to 15% or less of the total. But I would say that there is no industry sector in particular that we are planning on having a substantially increased proportion to, I’d say, would be more naturally to our selectivity. And what we find is more importantly, is properly capitalized has strong ownership and management and the characteristics we look for which are high free cash flow, low maintenance CapEx, modest no exposure to commodity prices. So those are the things we looked for, but none in particular that we are planning to grow meaningfully to achieve that goal.

Great. Thank you for taking my questions.

Thank you. Thanks for joining.

Our next question comes from David Miyazaki of Confluence Investment.

Hi, good morning.

Good morning, David.

This is kind of an accounting question just a nuance. But when you originate a loan and there are fees attached to it, do you just kind of explain how those fees are apportioned if you syndicate out some of that loan at closing versus if you hold on to it for a few weeks like what you have done here recently?

Sure. David, this is Todd. So in a normal case, of course, if we originate a loan and it stays on our books, the BDC keeps all those fees. If we syndicate it out after the fact, I would say that just is kind of – is an arrangement generally with the people that we are dealing with, but if the BDC originates it and it stays in the funds generally, the BDC will wind up with keeping the fees.

And I think maybe David, you specifically as an example the loan that we sold down in October, normally in this case there would have been, in this example, 2% of fees upfront better than amortized over the life of the loan say a 5-year loan, so you are picking up 40 basis points a year. And then if we happen to sell part of the loan down – and there are cases where we have been able to perhaps skim some of the fees or share some of the fees, those fees would be taken at that time, but the amount that would remain with us would continue to be amortized over the life of the loan.

Okay. That’s exactly where I was going. So I appreciate you are anticipating that. I was just kind of thinking that if you held the loan and all the fees were yours, then over time as you sell them off, then you are going to have some partial recognition of the fees that you haven’t amortized that were attached to what you sold. I presume does that also happen if you buy or if there was a discount accretion that was being amortized over the life of the loan that you have the same accounting treatment for that?

Yes, that’s correct.

Okay. So thank you. I appreciate that. I think that’s actually – I appreciate you amortizing over the life of the loan, I think that it’s better to recognize that when you get burden handy there from a maturity or when you sell the credit. So I appreciate that more a conservative accounting approach?

Yes. And it was of course illustrated in this third quarter. As Todd mentioned that we had a fair amount when these loans paid off earlier,, a fair amount of what we would call OID accretion. So roughly Todd, $300,000 of actual prepayment fees but maybe close to $600,000 was those fees paid upfront that now are coming back in early.

That’s right, yes.

Great. Well, thank you very much and congratulations on the quarter.

Yes. Thank you, Dave. Thanks for your support.

At this time, we have no further questions in the queue. And I would like to turn it back over to Mr. Robert Ladd.

Okay. Thank you, Cassidy and thank you everyone who joined the call and your support and we look forward to reporting our results again in the new year. Take care.

Thank you. Ladies and gentlemen, this concludes today’s teleconference. You may now disconnect. Thank you for calling.