Stellus Capital: 12% return, good things come in small packages

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Income investing doesn’t have to be a popularity contest, and that’s true for business development companies. While big BDCs like Ares Capital (ARCC) and Owl Rock Capital Corp. (ORCC) attract the lion’s share of the attention, there are smaller BDCs that also offer an attractive value proposition. This is especially because smaller BDCs have more room to operate and it doesn’t take as much to move the needle for them.

This brings me to Stellus Capital Investment Corp (NYSE: SCM), which is one of those small BDCs that now sports a high yield in the low teens (including special dividends). In this article, I highlight what makes SCM a solid income investment, so let’s get started.

Why SMC?

Stellus Capital is an externally managed BDC focused on providing debt financing solutions to middle market companies in the United States, with annual EBITDA in the range of $5-50 million. SCM went public in 2012 and received its first and second SBIC licenses in 2014 and 2019. Since going public, SCM has invested over $8 billion in more than 300 companies across 20 industries.

SCM has demonstrated strong performance over the past decade, achieving an annualized ROE of 9.86% over that period, placing it in the top 10 of all publicly traded BDCs. SCM has also demonstrated a fairly stable net asset value per share over this period, apart from a brief dip in 2020. As shown below, SCM’s net asset value/share of $14.59 is now at – above what it was at the end of 2019.

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SCM NAV/Sharing (YCharts)

This reflects management’s conservative lending practices, which focus on direct lending rather than largely syndicated financing. In most cases, SCM is the sole lender of the tranches in which it invests. This direct relationship with borrowers helps to facilitate individual dialogue and the establishment of a long-term business relationship, with opportunities for subsequent rounds of financing.

SCM’s portfolio is growing quite rapidly, with a 3-year CAGR of 17%. SCM currently holds a fair value portfolio of $838 million that is diversified across 78 investments. It also maintains relationships with over 170 equity sponsors, which ensure a healthy deal flow. As shown below, SCM’s major industries are diversified into generally core segments, including business services, healthcare, aerospace and defense, and media.

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SCM Portfolio Composition (Investor Presentation)

Meanwhile, SCM saw improving fundamentals for the business, with Core NII per share growing $0.01 year-over-year to $0.29 in the first quarter. Additionally, SCM increased its net asset value per share by $0.27 year-over-year to $14.59. Also encouraging, SCM’s dividend rate (regular and special combined) is now back to its pre-pandemic rate of $0.34 per quarter (paid monthly).

Management also maintains portfolio security, with 91% of the debt portfolio dedicated to senior secured loans, and most of the remainder (8%) dedicated to junior secured loans. Furthermore, non-accruals remain low, comprising only 3 loans, representing barely 0.7% of the portfolio.

SCM’s regular dividend rate of $0.28 per quarter is covered by its NII per share, and I see that it continues to be able to fund its special dividend amounting to $0.06 per quarter. This was due to the $23.7 million, or $1.22 per share, of realized gains SCM received on portfolio exits in 2021, and the $6.3 million of realized gains since inception. of the year.

Looking ahead, SCM is well positioned for a rising rate environment, given that 96% of its debt investments are floating rate. It also maintains a healthy regulatory debt-to-equity ratio of 1.07x, well below the statutory limit of 2.0x.

Potential risks to the thesis include a downturn in the economy. However, there could be a silver lining for SCM, as it partners with private equity firms that have plenty of dry powder to invest, and depressed tech valuations could lead to more M&A activity in these private equity firms, as noted by management during the Q&A session. from the recent conference call:

Q: When it comes to the slowing economy and rising interest rates, are private equity partners actually doing anything you might notice that are positioning themselves for the changing environment?

A: Sure. Well, then a few thoughts. First, the good news is that since almost all of our companies are owned by private equity firms, very smart investment professionals across all cycles. And certainly, we are preparing and thinking about the headwinds to come. So I think that would be normal, and that’s why we have the overall strategy.

We saw a slight slowdown in activity in the first quarter, but there is substantial dry powder in private equity firms. So we expect there will be more acquisitions throughout the year. But you would think that, again, with these headwinds, there will be even more selectivity and maybe you’ll see lower paid multiples for businesses, but we’re still waiting to see that.

But again, I would say the most important point of your question is how very positive it is for our portfolio to have such smart and capable investors coming back into the companies.

Finally, I view the recent decline in SCM’s stock price as an attractive high yield opportunity. SCM now yields 11.9% when special dividends are included. At the current price of $11.44, SCM is also trading at a significant discount to its NAV, with a price-to-book ratio of 0.79x. As shown below, this is at the low end of its 3-year range.

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SCM price to book (seeking Alpha)

Analysts on the sell side have a consensus Buy rating with an average price target of $14.50, implying a potential total return of 39% over one year, including dividends.

Key takeaway for investors

Stellus Capital Investment has a strong portfolio of investments, a high dividend yield and is trading at a significant discount to its book value. While there may be headwinds in the form of a slowing economy, I believe SCM is well positioned to weather them due to the quality of its portfolio and the private equity firms with which it associates. As such, I believe SCM is an attractive high yield opportunity in the current market environment.

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