Stellus Capital Investment Corp (SCM) 2018 Q3 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 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'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 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'd like to turn the call back over to our Chief Executive Officer, Rob Ladd.

Yes. We'll 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 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 cents 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've generated net gains both realized and unrealized of $5.9 million. And with that, I'll 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, 3 of these were new and 3 were existing portfolio companies. The 3 new investments totaled $26.8 million at par. All are first lien and have a weighted-average yield of a little over 9% all the loans are at floating rates. We had 5 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 3 loans on nonaccrual, which are $5.9 million combined, comprising 1.3% of fair value of the total loan portfolio and there were no additions of nonaccruals 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 funds. I'd 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 or 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 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 coinvestments. 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've had a small realized gain on one equity position of approximately $300,000. We funded $24.4 million at par in 2 new and 1 existing portfolio companies. Additionally, we have received $25 million in full repayments on 2 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'll open it up for questions, and thank you. And Cassidy, please begin the Q&A session.

(Operator Instructions) Our first question comes from Robert Dodd of Raymond James.

I have a -- on your comment you just made on a increasing percentage of unitranche, there's a couple of tiers to this question. But what would you say that you're 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 is 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 the respect to pure first lien, the leverage quotient for a pure first lien, might be in the range of 2 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 don't want to call it a change in size, per se, 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 wrapped up in the forward plan into '19. Obviously, you want to clear the portfolio, you can increase the leverage a little bit. Is the -- are those 2 intrinsically related, or would you be doing this rotation a little bit to more first lien, lower yield, even if the capital structure side of the BDC remained the same, I remember it's been 1:1, I mean how intrinsically are those 3 things tied together?

Yes. So great question, Robert. I'd 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've been on. There's no question that we're helped by having some incrementally greater leverage to have lower yields, but I think, it's just -- I think it's what we'd be doing anyway. And again, we're helped, of course, by having some additional leverage and as I've shared with you before, shared with our investors before, we're now targeting to get to a 1:1 leverage not -- much higher than that versus what we've been operating at like 0.7 to 0.8:1.

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's obviously another component that you could utilize, which would be the 30% bucket, 30% bucket can still be secured investments, I hope. But any, 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're doing right now, or is that just something that's maybe on the cards long term, but not a near-term 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've seen asset-based lending, subsidiaries, leasing-type subsidiaries. So we certainly thought about those. There's nothing imminent though. I think you -- for the near term expect that our investing will continue to look like it has with -- again, we're primarily financing the acquisition by a series, private equity firm of a private business. And along with that, we have the -- as part of our strategy to participate in modest ways of buying equity coinvestments effectively at par at closing. So I think that for the moment is certainly the primary strategy, but we'll certainly look at things over time, and you're good to raise that we do have the possibility to have drop-down subsidiaries that could be enhancing and diversifying, but nothing imminent on that front.

Our next question comes from Paul Johnson of KBW.

First, I'm just looking at your interest income debt portfolio shrank a little bit this quarter. I'm wondering was that driven mostly by the prepayments this quarter and should we expect that to kind of come down to maybe a more normalized level.

Yes. So thank you. Thanks for joining. So we were a little bit lower at quarter end than we thought we'd be. We had unexpected repayment or 2. And also, we've been -- we might have been higher, but we've been very selective in our investing and like we had one investment that we thought would be materially impacted by what's happening in China and declined to participate. So a little bit lower than we thought would be for the quarter. We -- it looks like we'll be close to flat to a 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 a little bit more than we were expecting. I'm 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'll call, it's nonrecurring 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 reclass of fees as loans pay off. So that -- that's a non -- 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. I understand. 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 Act, they increased the maximum borrowings under a license, to $175 million from $150 million. I'm wondering is that -- first off, does that apply retroactively to your current licenses that you have today? And I guess if it does not, are you in the process of trying to seek 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 on another license and can kind of report on that as we go forward.

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

For Wise Holding, it was a nonaccrual loan in second quarter and may have high conviction in this company. But could you please add more color on why put ambition of $300,000 in the first lien, the late long-term loan when you also marked on the loan by $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're conducting. But this is 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'll be watching the credit from here.

Got it. Okay. That's good. And another question about Good Source Solutions. I'm 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 looked 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?

Yes. So with respect to that portfolio company, we did have a -- maybe coincidentally I guess, we had a question last quarter about it was outside of our normal range of investing. And so sometimes, we'll 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're able to accomplish that by closing and 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 we -- positive about the company. It was just literally a risk-sizing issue. We'd like to have kept if we could, but again we try to have our largest positions be in the low 20s and ideally in the teens.

The next question comes from Christopher Nolan of Ladenburg Thalmann.

I take it that your previous target range of 520 to 540 by year-end is off?

Yes, we -- yes, we're targeting, as you may have missed the prepared remarks was that -- targeting that a range between 480 and 500 by this end of calendar year.

Great. And Rob, in your comments when you mentioned that you're going to be increasing leverage, eventually reaching 1:1. Do you have any idea when you might be able to reach 1:1. Right now, your debt leverage ratio 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 then 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 portfolio to that size?

We're open-minded about industry sectors, and -- but I'd say that we -- I'd 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'd say that there's no industry sector particular that we're planning on having a substantially increased proportion to. I'd say, would be more naturally through 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 if no exposure to commodity prices. So those are the things we looked for, but none, in particular, we're planning to grow meaningfully to achieve that goal.

Our next question comes from David Miyazaki of Confluence Investment.

This is kind of an accounting question, just a nuance. When you originate a loan and there are fees attached to it, can you just kind of explain what -- how those fees are apportioned, if you syndicate out some of that loan at closing versus if you hold onto it for a few weeks like what you've 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're 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 Dave, you specifically, as an example, the loan that we sold down in October, normally, in this case, that would have been, in this example, 2% of fees upfront that are then amortized over the life of the loan, say a 5-year loan, so you're picking up 40 basis points a year. And then, if we happen to sell part of the loan down then -- and there are cases where we've been able to perhaps skim some of the fees or share some of the fees. Those fees will be taken at that time. And -- 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 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're 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. 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 it when you get bird in hand either from at maturity or when you sell the credit. So I appreciate that more 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 early. 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.

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.