SCM - Stellus Capital: A 12.2% Yield Paid Monthly 4% Discount To NAV

2023-10-09 13:40:36 ET

Summary

• Stellus Capital currently yields 12.2% and comes with a monthly dividend payment schedule.
• The dividend is 123% covered by GAAP net investment income as of the end of the most recent quarter.
• A 4% discount to NAV that's rising could present an entry point as the US economy continues to notch growth.

Stellus Capital Investment ( SCM ) has a total debt-to-equity ratio of 1.87x, amongst the highest in the business development space. The BDC last declared a monthly cash dividend of $0.1333 per share , matching its prior payout and for a 12.2% annualized forward yield. This is a double-digit yield that's safe against SCM's most recent net investment income per share and is set for growth as the Fed funds rate stays higher for longer. Whilst, SCM has been dipping from its recent highs, the trendline for the BDC's book value, or net asset value, has maintained an upward move that's been in place since 2021. NAV came in at $308.32 million, around $13.67 per share, as of the end of its fiscal 2023 second quarter. SCM is currently swapping hands for a 4% discount to NAV per share on the back of a selloff from recent highs as the market looks to price in what higher for longer means for the economy.

I have a sizable stake in the BDC, built on the back of the positive direction of NAV and its roughly $881 million portfolio at fair value. The BDC's investment portfolio has grown at an 11% compound annual growth rate over the last three years with the credit portfolio 97% invested in floating rate loans with a heavy 95.2% first lien weighting as of the end of the second quarter. This was up from 92% in the year-ago period. However, bears have flagged some risks from non-accruals, the high leverage ratio, and the specter of a recession ramping up credit risk as reasons to stay away from the ticker.

Diving Into The 12.2% Dividend Yield

SCM's higher leverage ratio does ramp up risks a potential recession might pose, but the most talked about recession looks ever beyond the horizon with a blowout October jobs report underlying the continued strength of the US economy. I'm in the BDC for the income and strength of NAV and SCM last reported second-quarter total investment income of $26.6 million , up 65.1% over its year-ago period and a beat on consensus estimates by around $1.14 million. Core net investment income, which excludes the impact of capital gains incentive fees and income taxes, was $10.8 million , around $0.51 per share, and up 76% from $0.29 per share in the year-ago quarter. GAAP NII per share was around 2 cents lower at $0.49.

The BDC's significant leverage ratio overlayed with floating rate loans has expressed itself as hyper-growth when aggregated with the marked rise in base rates to 22-year highs at 5.25% to 5.50%. SCM made $46.5 million in new investments during the quarter against $38.4 million in repayments for $8.1 million of net new investment activity. Critically, these new loan fundings were 100% first lien and with a weighted average yield of 12.19%. SCM's loan portfolio currently yields 11.4%, flat sequentially from the first quarter, but up from around 8.5% in the year-ago period. GAAP NII provided 123% coverage against the 3-monthly aggregate of the monthly dividend, a roughly 81.6% payout ratio.

Risk And Non-Accruals

SCM had five loans on non-accrual status, around 3.3% of the fair value of the loan portfolio, as of the end of the second quarter with the BDC also recording an unrealized loss of $6.3 million from company write-downs. Among the investments on non-accrual status were three term loans to EH Real Estate Services. These first lien term loans were marked as non-performing from the start of 2023 with management stating during their second-quarter earnings call that this deterioration in the performance of EH was due to a slowdown in the housing industry in the Midwest which has sparked a disruption of real estate residential closings.

SCM has around 86% of its portfolio rated at one and two. Investments rated as one are at 25% as of the end of the second quarter and were up from 17% in the first quarter. Further, around 14% of the portfolio was marked investment-grade category of three or below, down around 500 basis points from the year-ago period. Hence, we have rising NAV against a portfolio with a heavier first lien rating, higher yield, and lower intrinsic risk across its investments. SCM's core inherent headwind is seemingly from its high leverage ratio which the BDC needs to start reducing going into 2024 which holds the potential to bring unexpected economic disruption even with the current macroeconomic picture being somewhat positive. This ticker could see a move up on the back of an increase in the dividend which is possible with the payout ratio currently below the 90% BDC requirement. I'm rating the ticker as a buy.

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