Stellus Capital Investment Corp (SCM) 2018 Q1 法說會逐字稿

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 first quarter 2018 results. (Operator Instructions) This conference is being recorded today, Tuesday, May 8, 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, Melanie, and good morning, everyone. Thank you for joining the call. Welcome to our conference call covering the quarter ended March 31, 2018.

Joining me this morning is Todd Huskinson, our Chief Financial Officer, who will cover important information about forward-looking statements.

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 Investor's 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. As in past quarters, my remarks will cover the following areas: First, our investment portfolio, including asset quality; second, operating results; and third, outlook.

With respect to our portfolio, we had solid portfolio growth during the first quarter of $56 million net of repayments. We ended the quarter with an investment portfolio at fair value of $431 million. During the quarter, we made $71.7 million of investments in 4 new and 4 existing portfolio companies. The 4 new investments totaled $52.5 million and are 80% first-lien and have a weighted average yield of about 10.5%. This growth is the selective deployment of the capital raised in 2017 through our equity offering, notes issuance and additional SBA debentures. We had one full repayment of $9 million and $6.7 million of amortization and other payments during the quarter.

Overall, our asset quality is stable at 2 on our investment rating system, or on plan; there were no additions to risk rate 3s; only 9% of the portfolio is marked at an investment category of 3 or below, which is below plan; and we have just 2 loans on nonaccrual, which are $1 million combined, representing only 0.2% of fair value of the total loan portfolio.

We continue to maintain good diversification with the largest industry sector at 10.9% of the total. The average investment per company is $8.3 million, and the largest investment is $22.2 million, both at fair value.

Finally, our portfolio continues to become increasingly more weighted towards secured lending and at floating rates. At March 31, 93% of our loans were secured and 89% were floating, both up slightly from year-end. I would note that this position of 89% floating rate portfolio is very helpful in the current rising interest rate environment. Also, as a reminder, our only floating rate liability is our bank facility, which today, is approximately 20% of the total of our debt.

Now turning to operating results. We generated realized earnings of $0.36 per share, which included a realized gain on an equity co-investment of $0.08 per share. While realized earnings covered our dividend, earnings from net investment income fell short of the dividend by $0.06 per share.

Net asset value increased $0.12 per share from $13.81 at year-end to $13.93, primarily due to appreciation on our portfolio and the previously mentioned realized gain.

Now turning to outlook. For the balance of the second quarter, this is what we know as of today. We've made $43.2 million of new investments since March 31, in 4 companies, and have had one payoff of $12.1 million, so our portfolio today is approximately $458 million. The weighted average yield is essentially the same as March 31. We are expecting one additional full repayment of $2.5 million. Although we are actively working on new investments, we are not projecting any material new fundings between now and June 30. And then lastly, for the quarter, we are aware of one possible equity co-investment realization for the quarter, which would generate a $2.6 million gain. It could move into the third quarter, but it's likely, we think, it will happen this quarter.

Now turning to the balance of the year. Our investment goal for the year-end is to get to $500 million of investment portfolio. This amounts to a net increase of $25 million for each of the third and fourth quarters. We're not aware of any material repayments through the balance of the year, but history would tell you we'll certainly receive some.

Lastly, I'd like to address the leverage situation for the sector. As you know, they recently passed legislation that allows BDCs to operate with greater leverage, increasing the regulatory cap from 1:1 to 2:1. On April 4, our board approved such an increase, and we are seeking shareholder approval at our Annual Shareholders' Meeting as well. Our board, and we, as management, believe this increased leverage capacity is very positive for our shareholders. We plan to use the increased leverage when available, moderately. Initially, it will allow us to operate at, say, a 1:1 leverage instead of the 0.7 to 0.8:1 where we've been operating. This should allow us to increase our investment portfolio by 50-plus million dollars. The first step toward operating at this higher level of leverage is to obtain a modification to our bank credit facility leveraged covenant, which is currently at 1:1, and then the second step would be to obtain increased dollars of leverage, which will most likely come from unsecured notes.

Again, our view that the increase in the leverage limitation will be very positive for our shareholders. The key is to use the increased capacity moderately.

With that, I'll open it up for questions.

(Operator Instructions) We'll go first to Christopher Nolan with Ladenburg Thalmann.

On the non-accruals, the press release said 2 non-accruals -- you've got Grupo Hima. What was the other one? Is it still Binder & Binder?

Yes. It's the remainderment of the Binder & Binder position, which we could report. The $100,000 of the remains was fully retired at the end of April.

Got you. And then the expenses increased, particularly for management accruals and interest expenses. Can you give us any guidance as to where things could go in the second quarter for expenses?

Yes. To make sure we heard you, Chris. The question is about expenses, generally? And...

Yes.

Okay, sure. One thing I'll note, and then I'll turn it over to Todd. But in the first quarter, our professional fees are higher than they are through the rest of the year. But Todd will address that. And I think that's part of the increase.

Yes, that's right, Chris. So I would say the increase in this quarter, and to some extent, the end of last year, was related to the implementation of -- or the auditing of Sarbanes-Oxley, which was -- led to increased audit fees, because they had to audit our controls. Plus we had some consulting fees related to getting us prepared for that. So we'd expect that to be considerably less going forward. And including the first quarter of next year when you have all those same kind of fees, we expect those to be less for that period as well. But that's it. Everything else was relatively stable.

Great. And then finally, my last question. Rob, I missed it in your comments when you mentioned a possible equity gain in the second quarter, what was that, please?

Yes. We have one of our equity co-investments, we believe the business will be sold by the end of the quarter, and the gain is -- expected gain is $2.6 million.

We'll go next to Robert Dodd with Raymond James.

First, a couple on -- you had considerable dividend income in the quarter. I mean, I'm going to presume, unless you tell me otherwise, that those were one-offs between Millennium Trust and Glori. Any indication those are going to be recurring? Or were those just one-off receipts in Q1?

Yes, Robert. So this is Todd. So that was really related to Millennium Trust. And that -- you could have another one of those in the future from there, but it's not a recurring dividend that you should expect. So we don't have any knowledge that there'll be another one, but it's possible that there will be.

And then I mean, the Glori energy was $900,000 as well, which was pretty sizable. Is that one, again, a one-off, or ...

It was. Yes, that was the -- that was basically going to be the sale of that company. And so that was a one-off investment, a one-off return.

Robert, just a quick update on that. That was our one oil and gas position, and it's somewhat dated. So as we had projected last year, we thought we would sell those assets within 12 months, which we have. So all of the capital has been realized. There's a small stub piece, which is effectively cash of about $130,000. And after that business is wound up, that would also be distributed. So that position has basically been fully realized.

Got it, got it. And then just on the leverage, as you said, obviously, you've got to modify the credit facility. Any indication from discussions so far how that's going to go, guidance, indications on what the cost of a new modified 2:1 versus 1:1 compliant credit facility would be in terms of the spread?

Yes. So we've had initial discussions, or informal discussions, with a couple of the banks, including the agent bank, and they've been -- received it positively. We're not expecting there to be a material change in the cost. And one thing that might be helpful, as I was commenting in my prepared remarks, that what we think this new raising of the limit does is allow someone like us to operate at 1:1 instead of maintaining that cushion. So think of a covenant from the bank group to give us a cushion above the 1:1. So I think that our sense is that it's not meaningfully more leverage, but it'd be a much more efficient way to operate in terms of leverage. So again, don't expect it to be a material cost. And we've had good response so far. But ultimately, that will be up to a formal request in the full group. But so far, they're supportive.

Got it, got it. I appreciate that. Last one on that, obviously, board's given approval. So in principle, that kicks in during the second quarter of next year and makes it available. Hypothetically, if shareholders don't vote to approve it, I mean -- the rules say either, right? You've already got a board approval. So what would your position be if the shareholders do? And I'm not saying that I think that's how it's going to be -- if shareholders do vote no on that?

Yes. So first of all, we expect that we'll receive approval. It's a simple majority vote. We think it's as I've said, we think it's very positive for the shareholders, so we'll be working to make sure that they understand that. And if in some small case, it was not approved, we would think about it. But our plan is that because this is so positive for all of our shareholders, that we would implement it then in the following April.

And we'll go next to David Miyazaki with Confluence Investment Management.

Just a couple of questions. One of the things, as I look at the 2:1, that is somewhat troubling when you look at the math, and I understand you're not talking about going way beyond the 1:1, but generally speaking, if you include the cost of putting the facilities in place, the non-usage, the actual costs, I kind of estimate borrowing costs off of a line of credit at around 5% for the industry, roughly. And then roughly, about 400 basis points in management fees, incentive fees and operating expenses, right? So in that environment or those basic assumptions, it's really hard for me to look at industry as a whole and think that 2:1 is really going to do a whole lot for either the quality of the assets that are being put on the balance sheet, because I don't think that you can get a 9-plus percent return on a senior secured floating piece of debt, it looks like this is something that could grow assets but do very little for the ROE. So I'm not saying that, that's necessarily your plan or your situation, but if you think about 2:1 over time and your company growing, how do you reconcile that really basic math versus your long-term plans?

Okay, yes. Thank you, David. So as you've pointed out, we're not thinking about anything close to 2:1 leverage. So again, we think that, used moderately, it's very beneficial. So maybe I'll explain it in a few ways. So the first is that this will give us a larger portfolio, of which we'll be able to win larger transactions. And as you know, we split new investments with our private investment fund 50-50, so it gives us a larger capital base, if you will. The second thing is that the use of leverage, and say, it's at 1:1 or slightly above 1:1, that's very modest leverage, and that especially when you look at the credit facilities, including unsecured notes and SBA debentures and they are longer-dated maturities, so you have a lot of to manage within the period, if you will, for multiple years, so we think that leverage is not high at that level, and that the costs associated with the leverage is also relatively not high. And as you can tell from our portfolio, our average yield is roughly 11%. The other thing that's not included in our yield is the equity co-investment portfolio that we've been building, which we think, on average, adds to the yield of the portfolio. So, again, that's our approach to it. I don't disagree if someone in the industry operated at 2:1 leverage and right on the margin and -- but that would be different. But that's not what we're advocating. So again, we view this as quite positive.

Okay. Well, I appreciate that. I think that we've seen a pretty wide range of approaches to adopting this. In some cases, the math I laid out is pretty apparent for some of the peers in the industry. And yet, there's a great -- there has been, for some, a great rush to get this approved by the board and get the one-year clock started. So I appreciate you guys being thoughtful about this and really thinking about what the incremental capital is doing for the shareholders. Because I get the sense from some of the management teams, 2:1 is something that is an opportunity that does incremental things for the external manager. I would say, just to follow-up on Robert's question about the shareholder vote, I do appreciate you putting it out there. I think it's important to get the temperature of your shareholder base. But I would also question the decision in a year to move forward with it if your shareholders voted against it. Can you kind of walk through why you might do that?

David, we're losing you there, just at the end. Is the question of why seek a shareholder vote?

No. No, no. If the shareholders said no, why would you still go forward with it in a year?

Because we think it's in the best interest of the shareholders over time. And so I would just say let's focus on getting the shareholder vote, which is what we're up to. And again, we're optimistic that it will be approved because of all the positive reasons for it. And the other thing I'd say would be -- with respect to your question about concern about the sector, that this may be a time when investors will differentiate between managers who use leverage responsibly.

I certainly hope so. There's a lot differentiation that, in my opinion, still needs to take place in the industry. But I would say that if you ask your shareholders if this is what's good for them, and they say no, and you go ahead and do it because you think it is good for them, that's not something that is going to instill a lot of confidence among your shareholder base. And that kind of segues into my last question in regards -- with regard to capital allocation. So I think that you guys were patient and thought long and hard to get over NAV in your stock price and issue the equity above book value, which is a great capital allocation discipline, one that is oftentimes not followed in the industry. But subsequent to that equity offering and your stock, along with most of the industry trading below net asset value, it is troubling to me to see that you're utilizing a mark-to-market -- I'm sorry, an at-the-market program to issue incremental equity, even if it's a small amount below net asset value. It kind of puts you on the wrong side of capital allocation discipline. So could you kind of walk through why you would continue to do that?

Sure, David. Again, you're kind of cutting in and out, but I believe the question is using our ATM program and potentially issuing shares below NAV. So is that correct?

Yes.

Yes, okay. So we issued a modest amount of shares that were slightly below NAV. As I recall, they were within 97% or 98% of NAV. And the approach we were taking and have been taking is that if we -- in using such an ATM program, that on average, over time, such issuances would at least be at NAV or above. So again, it was a marginal difference. So that's the approach we've taken. And Todd, if you might remind me, I think the amount issued is very small.

Yes, I think it's about 300,000 shares, for maybe $4 million of equity.

Yes. Yes. So that's the approach that we took.

So then if you're working to a long-term average then of getting at net asset value through the ATM, or higher, is it safe to assume that when you look at your stock right now, 87-ish percent of net asset value that you're not interested in doing at this level or anywhere near it?

That's correct. Yes, that's well said.

Okay. That's helpful. One of the problems with crossing that line, just going below, for shareholders, it kind of creates a situation where we don't know where the line is anymore. And that's part of the hazard in how you communicate to us what your capital allocation policy is. So it's helpful if you just never cross, because then we just know, it's net asset value.

Sure, sure. Sure, understood. And David, one thing, just to go back to the question about leverage and shareholder approval. So ultimately, that decision that I'm describing will be the purview of our Board of Directors. But I've tried to give you a sense of what we're thinking as management. As you know, the benefit of a shareholder vote is that, whereas the board approval, the increased leverage capability takes place a year later, if our shareholders approve it, we would be able to -- it would take effect immediately. In our case, the end of June. And that's why we are seeking the shareholder approval. Last thing I'd say is we're very optimistic we'll achieve it, and if we need to educate our shareholders why it's in their best interest, we're in the process of doing that. So -- but thank you for your observations as well.

We'll go next to Christopher Nolan with Ladenburg Thalmann.

Assuming that you get the approval for the increased leverage at the June 28 Shareholder Meeting, should we expect the leverage ratio to start climbing in the third quarter? Or should we expect an unsecured debt offering then? I mean, what's sort of the plans for the second half of the year?

Yes, Chris. That's a good question. So the need for the capital, increased capital, is out a ways. So a lot of it will depend on new investments that occur over the next 3 to 6 months. So I think the more likely case would be that the need for the capital would come toward the end of the year. And then in terms of assuming that -- we don't believe that the bank facility would increase materially in terms of the borrowing base. The borrowing base has been set. So that's why we think that most of this increase would come through unsecured -- senior unsecured notes. The issuance of those, I think, will be kind of as the market creates the opportunity. So whereas the need for the capital probably won't come until, say, the fourth quarter, we may try to look at a note offering in the meantime. The reason is to capture what we'd hope -- what may very well be lower rates than you'd see in the future. So -- but in any event, that's the timing. And the note offering timing is not known at this point. We'll be watching the market and -- but I'd say our goal is, certainly, by the end of the year, to have gotten to that point.

And have you done any sort of -- I mean, I'm echoing what David said earlier from the standpoint that, as you increase the leverage to a certain point, your borrowing costs can go up, your yields can go down a little bit. And you reach a tipping point where the return to shareholders actually go down. And can you give any sort of color in terms of the discipline? Or how are you balancing the amount of leverage going forward with the returns? I mean, do you have a particular ROE type of metric, an IRR-type of metric, that you've had before and that might change going forward? Any color on that would be helpful.

Sure, sure. I think the rough math is, as I said earlier to David, if you think of our portfolio yielding -- it currently yields 11% on a weighted-average basis. So think of it as 10.5% to 11.5%. That's your income side. And the cost of borrowing on the margin today varies between 4s to, all-in, to 6, including unsecured notes, including sales load. So we think there's a meaningful margin, there. And every dollar of increased leverage, again, moderately taken down and deployed, is accretive to our investors.

Okay. So and Rob, you're sort of thinking about a 500-basis-point, or so, spread, and -- as sort of the operating assumption at the moment?

That's correct. And then the other sources of income associated with a portfolio are one, call protection if a loan pays off early, which enhances yield; and then two, the co-investment portfolio, neither of which are included in that weighted average yield that I described earlier. So that's the rough math. And again, this is without issuing any additional equity.

We'll go next to Chris Kotowski with Oppenheimer.

Most of mine were asked, but I was just wondering, how much capacity do you have left -- is there any capacity left on the SBA? And how does that figure into your thinking about the 1:1 that you'd be going to? I mean, is it -- is that the statutory leverage that you'd go to that level? Or the kind of all-in leverage?

Sure. Sure, Chris. So with respect to the SBA debentures, so we've recently taken down $40 million more, which gets us to $130 million of outstanding debentures. So there are $20 million remaining, which we plan to call likely in the next 30 days or so. So we'll have obtained all of the possible leverage of the SBA. And then in terms of the leverage quotient, so we think about them differently. So the leverage that I've been describing would be leverage excluding the SBIC debentures, which as you know, is excluded for both the regulatory as well as the various leverage covenants with credit facilities. So ultimately -- and the reason we think about it differently is the long-dated nature of those debentures, which once they're pooled, are a 10-year kind of interest-only note. So we put those in a different category. Ultimately, we certainly would look at the total leverage of the enterprise, including those. But what we're thinking of, and as I mentioned, getting to 1:1 or so, would be excluding the debentures.

Okay. All right. That's it for me -- well, I guess just one last thing. Everybody is worried that you're going to use the additional capacity to leverage in a suboptimal way, or -- but I mean, isn't it effectively a free option? I don't see what the downside is in having that available.

We agree.

And we'll go next to Robert Dodd with Raymond James.

Actually, my follow-up was about the SBA, and you just answered it.

And we have no other questions at this time.

Okay. Thank you, everyone, for your support, and we'll look forward to being on the phone with you in August, and certainly, come to Houston for our shareholders' meeting, which will held on Wednesday, June 28. Okay, thank you.

That does conclude today's call. We thank you for your participation. You may now disconnect.