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Stellus Capital Investment Corp (NYSE:SCM)

Q4 2013 Earnings Conference Call

March 7, 2014 11:00 AM ET

Executives

Robert T. Ladd – Chairman, President, Chief Executive Officer and Chief Investment Officer

W. Todd Huskinson – Chief Financial Officer, Chief Compliance Officer, Treasurer and Secretary

Analysts

Kyle M. Joseph – Stephens, Inc.

Troy L. Ward – Keefe, Bruyette & Woods, Inc.

Dennis Robert Dodd – Raymond James & Associates, Inc.

Chris M. Kotowski – Oppenheimer &Co.

Operator

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 Fourth Quarter Financial Results. At this time, all participants have been placed in a listen-only mode. The call will be opened for a question-and-answer session following the speakers’ remarks. This conference is being recorded today, Friday, March 7, 2014.

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.

Robert T. Ladd

Thank you, Maris. Good morning, everyone, and thank you for joining the call. Welcome to our conference call covering the year ended December 31, 2013. 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.

W. Todd Huskinson

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 numbers 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 Stellus Capital Investment Corporation 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.

Robert T. Ladd

Thank you, Todd. We are pleased to report our results for 2013 which was our first full fiscal year of operations. During the year we increased our investment portfolio about 42% with approximately $175 million of new investments. This growth was achieved net of approximately $100 of repayments and realizations and we also further diversified the portfolio. In 2013 we generated income that substantially paid for the regular dividends and a special dividend which equated to a yield in excess of 9% based on our IPO price at $15 per share.

During the fourth quarter we made $47.3 million of new investments in four portfolio companies and three existing portfolio companies and received one repayment totaling $12 million. We also received $1.3 million of amortization of non-existing loans. Our pipeline is robust and we are seeing a number of interesting opportunities. At this point, I’d like to share some information about our investment portfolio.

So as of December 31, 2013 we had 26 portfolio companies with total investment of approximately $277 million. The debt portfolio makes up almost all of the total. The weighted average yield on the debt portfolio was approximately 11.4% at year-end, unchanged from September 30, 2013.

Our risk rating perspective on a weighting average rating is slightly above 2, which means performing is expected on a 1 to 5 of scale. 22 of our investments are rated 2, two investments are rated 1, one is rated a 3 and one rated a 4. We had no loans on non-accrual status during the fourth quarter. However the loan rated a 4 was placed on non-accrual as of January 1 of this year. Twenty four of the twenty six companies are backed by a traditional private equity sponsor.

As we stated over a year ago, we remain focused on meeting our goals which include; first, generating sufficient income to cover our dividends; second, maintaining high asset quality; and third, selectively growing the portfolio in a diversified manner.

This December 31, we’ve made three new investments totaling approximately $16 million. We’ve received one repayment of $10 million and had realizations on 3 investments totaling approximately $7 million, which leave the investment portfolio currently at approximately $276 million. With that, I’ll turn it over to Todd to cover the financial results.

W. Todd Huskinson

Thanks, Rob. Our total investment income for the quarter and year was $7.7 million and $29.4 million respectively, most of which was interest income. Operating expenses totaled $3.5 million for the quarter and consisted of base management fees of $1.2 million, incentive fees of $0.6 million, fees and expenses related to our credit facilities of $0.9 million, including interest and amortization of deferred financing costs, and administrative expenses of $0.2 million and finally other expenses of $0.6 million.

Net investment income for the quarter was $4.2 million or $0.35 per share. For the year-end 12/31/2013, net investment income was $16 million or $1.33 per share. As Rob noted, during the fourth quarter we had $13.3 million of repayments including $1.3 million of amortization of existing loans and we added $47.3 million of new investments during the quarter.

The new investments were as follows, a $21 million investment in the second lien loan of Empirix, a provider of sophisticated testing and monitoring software systems for Voice-over-Internet-Protocol networks. We also invested $1.3 million in the company’s equity.

A $9.8 million investment in the second lien loan of Calero Software, a provider of outsourced Communications Lifecycle Management software solutions to simplify telecommunications operations for enterprises. We also invested $500,000 in the company’s equity.

A $6.6 million investment in the second lien loan of Hostway, a provider of web hosting solutions including managed hosting and cloud solutions, as well as shared hosting and domain services to over 570,000 end user customers.

A $4.9 million investment in the unsecured loan of SQAD, which provide databases and software tools to the advertising industry to help plan, negotiate and benchmark the sale of advertising inventory which includes airtime and internet ad space. We also invested $500,000 in the company’s equity.

We had a follow-on funding of $1.5 million in the second lien loan of Securus, which provides telecommunication services to the correctional services industry. A follow-on funding of $1.1 million in the revolver of Refac, which is the holding company of two optical retailers, U.S. Vision and OptiCare Health Systems. A follow on funding of about $147,000 in the equity of Eating Recovery, which is a nationally recognized facility for the treatment of eating disorders.

And finally we received full repayment of our first lien loans of Holley Performance Products at par plus a 2% prepayment premium resulting in proceeds of $12 million.

As of December 31, 2013 our portfolio included approximately 17% first lien debt, 43% second lien debt, 38% mezzanine debt and 2% equity investments at fair value. Our debt portfolio consisted of 42% fixed rate loans and 58% floating rate investments.

Our average portfolio company investment was approximately $10.7 million and our largest portfolio company investment was approximately $22.3 million. Additional information regarding the composition of our portfolio is included in the MD&A section of our 10-K, which was filed yesterday evenings.

With respect to liquidity, at December 31, 2013 we had $110 million borrowed under our credit facility and today we have $104 million borrowed under that facility. And with that I’ll turn the call back over to Rob.

Robert T. Ladd

Thank you, Todd. And Mar, you may begin the question-and-answer session please.

Question-and-Answer Session

Operator

Thank you very much. (Operator Instructions) And we will go to our first caller, Mr. Kyle Joseph with Stephens.

Kyle M. Joseph – Stephens, Inc.

Good morning guys, thanks for taking my questions. I wanted to get into the investment you placed on non-accrual. I just went through the K and it looks like it’s been there and been there. Can you give us – first of all is that correct? And then second of all, could you give us a little bit of color of what’s going on with that company and prospects for a workout?

Robert T. Ladd

Yes. So we can’t confirm it. Just as the matter of call, here we don’t like to talk about the particulars of private companies in detail. But this is a company that we’ve been involved in for some time. It has a private equity sponsor behind it. They’ve been impacted by a couple of things in the market place and we’re working through it. And hard to predict the prospects ultimately, but you can market it what we think is the proper value again of the year and are working through it other than it will take certainly some period of time. But again, we prefer not to talk about particulars of individual private companies.

Kyle M. Joseph – Stephens, Inc.

Okay, thanks. And then aside from that company, can you talk a little about the performance of other companies in terms of revenue and EBITDA growth and then overall interest coverage and leverage on the portfolio?

W. Todd Huskinson

Yes. In terms of the – probably the way to talk about this is overall trend. So thus indication for us is our risk rating system, which I highlighted earlier. So think of substantially 22 of the portfolio companies, 26 are performing in line with expectations, which could also mean improving revenues and EBITDA but generally speaking performing the way we would expect them to perform. So as a portfolio that we’re seeing good results, these are almost all private businesses, getting to all private companies at this point. And their performances as we would expect is slightly better.

Yes, it’s not unusual to have something go from a two to a one if there is better than expected performance. And then also to have something go from a 2 to 3 which is [indiscernible] which is as you know we do have one credit bits of three. So our portfolio is in total represents a lot of middle market businesses, United States are performing nicely.

In terms of the leverage ratio, we’ve seen as and I’ve reported on this previously as we’ve added through 2013 some larger companies with larger EBITDAs that $40 million, $50 million, $60 million range our leverage relationship has gone up closer to the all in five times leverage. But as we invest in businesses that are smaller and they tend to be less leverage for us and we are seeing that starting to come down a little bit. We have very good interest coverage and free cash coverage on the loans that are performing as planned. And you can imagine if something is under planned and it would be off of that. But substantially performing well again based on the overall risk rating 2.

Kyle M. Joseph – Stephens, Inc.

Okay. And then as you guys did declare a special dividend, did you have any spill over income after that?

W. Todd Huskinson

Yes. We still have about $200,000 of income that we did not payout with respect to the – with the special dividend.

Kyle M. Joseph – Stephens, Inc.

Great, thanks so much for answering my questions.

Robert T. Ladd

Yes, thank you Kyle.

Operator

For our next question we go to Troy Ward with KBW.

Troy L. Ward – Keefe, Bruyette & Woods, Inc.

Great, thank you, and thanks for taking my questions. Can you speak real quickly about the quarter-to-date yields you’re seeing and the originations that are already done and what’s in the pipeline?

Robert T. Ladd

Yes, Troy. And so this will be the first quarter 2014. Of the deals that have been – investments that have been added so far, their all in yields would approximate what we prefer to do at the end of the fourth quarter for the entire portfolio and their leverage relationships are less than the portfolio. So we’re seeing less leverage on. Again these are more traditional businesses for us. On the deals that paid-off, their yield on average was less than the average. And their leverage was higher than the leverage we are adding. In some nation we are starting to see probably better yield and slightly less leverage.

And then the pipeline of deals yet to be closed, the yields that we’re looking at would be at least equal or better than the average and the leverage is slightly less, so again a continuation. As I mentioned earlier, we are very active in the market place currently seeing interesting opportunities and optimistically we’ll continue to build the portfolio.

Troy L. Ward – Keefe, Bruyette & Woods, Inc.

Okay. That’s a big counter to maybe what we are hearing from some of the other players. It sounds like you’re seeing better investment opportunities on both aspects, on pricing and leverage. Do you feel like you’re getting different looks than some of your competitors and then how do you makeup that’s you are seeing such better opportunities?

Robert T. Ladd

Yes, Troy, I would say that – first, we’ve been in this business for approximately a decade. So very, very active in the market place and good relationships with many of our competitors of course we too. I think it’s probably more a trend in 2013 as we were building and diversifying the portfolio. We ended up with some larger businesses with larger EBITDA and higher leverage and lower yield. And more of what we’re looking now in the first quarter – end of the fourth quarter and the first quarter. It’s more of our traditional business, that are smaller EBITDA businesses and better pricing and better leverage.

Troy L. Ward – Keefe, Bruyette & Woods, Inc.

Okay, can you speak to the structure, particularly the call premiums on the new deals versus what you are seeing, what’s already in the portfolio?

Robert T. Ladd

Yes, so I’d say that the nature of call premiums we think are relatively stable. So we do see call premiums on almost every transaction we’re involved in. It will be less if it’s first lien senior loan and more that if it’s in your mezzanine capital loan. But we’re still seeing good call premiums including the first and second year and also the third years. And I would say that it’s probably the same level we’ve seen over the last six to nine months. Certainly not the same that we saw two years ago, but we certainly see stability in call premiums and for that matter [indiscernible].

Troy L. Ward – Keefe, Bruyette & Woods, Inc.

Okay. And then one final one, on the SBIC I know you will have a lot of color. You probably can’t provide a lot of clarity on exactly when – what you’re expecting, you’re hearing from them. But could you speak to kind of the process and assuming that when you do get the license talk about how you fund the initial capital required to fund the license and at what levels?

W. Todd Huskinson

Yes. So in terms of the processes we’ve reported before that we won’t know until the SBA makes a final determination. But I would say that we’re cautiously optimistic. But again with the qualification that ultimately we are not in control of the process. We are working very closely with the SBA and we should know at some point.

In terms of how we’ll fund it, so we have certainly our existing capital base that is being used to effectively pre-license transactions. Once certainly we received approval, you do licensing of existing capital base. And of course it would be opportunity time to raise additional equity capital at the SBIC level, which it helps further capitalize the subsidiary, but currently will be capitalized from the capital we already have. We certainly will as you go through that process to take advantage of the SBIC leverage debentures, but as you know it take sometime first need to build the portfolio of equity and then access to debentures there after.

Troy L. Ward – Keefe, Bruyette & Woods, Inc.

Great, thanks guys.

Robert T. Ladd

Yes, thank you Troy.

Operator

We move now to Robert Dodd at Raymond James.

Dennis Robert Dodd – Raymond James & Associates, Inc.

Hi, guys following up on Troy’s question on the SBA, you mentioned essentially pre-accrued transactions. Can you give us any color on all your recent deployments have been appropriate for an SBA vehicle and if any of your existing deals have been preapproved within an SBIC if you get the license?

Robert T. Ladd

Yes. So probably in fairness of the SBA, I shouldn’t comment further about, until we receive notice about a license, but I would say that with respect to our new originations that many are fitting nicely in the SBA size and portfolio fit.

Dennis Robert Dodd – Raymond James & Associates, Inc.

Thank you. I’ll just – going to the pipeline of mix as well I mean obviously one way to manage yield to generate high yields. Obviously move a bit down market back to your core so to speak. We have all received a shift mix, I mean you’re at about 38% mezzanine now, 40% second lien, on the 20% per say. On the pipeline that you are seeing and not even necessarily the eminent, eventually eminent transactions, but the one just starting to get indications, so if I look at the color, longer than particular mix in your pipeline. What kind of deals are you seeing? You’re seeing it’s giving more towards second lien more towards mez, that it was in last year or are you targeting any particular different mix than you currently have in your portfolio.

Robert T. Ladd

So Robert, historically we’ve found that our portfolio mix has been approximately a third in first, firstly on a the tranche in third and second, and then third in unsecured mezzanine. As we sit here today, we are similar to the same percentage as we had at the end of the year, but as an example of a couple of deals that we are working on are actually first lien. One is the first lien last-out and the other is the first lien.

So I think we probably would defer to what our historical experience has been in that breakout. But I think it would be fair to say we’re not, like everything we’re looking at is it’s not all mezzanine capital. It’s I think a good mix, but historically as you know that, our business has been more geared towards achieving new capital versus first lien secured lending. So but in any event our origination approach we do find interesting first lien months at the same time. So I don’t think it’s a big shift away from first lien but rather our traditional business and it is spitting nicely again. Through the out days we’re looking at our first lien.

Dennis Robert Dodd – Raymond James & Associates, Inc.

Okay, thanks. And then just lastly on that kind of pipeline more extended concept I mean any color on volume of preliminary deal suites that are coming across your decks, kind of – how you expect that. What the early indications are about how you expect to gear the shake out.

Robert T. Ladd

Yes, so again hard to predict the future but our credit line is $104 million today and based on your investments we would expect to be fully invested this year. And what we don’t are our repayments. We know, only know one certain repayment, a company has being sold and the investment is approximately $10 million, but whereas last year we saw roughly $100 million of payoffs. We don’t see that volume coming this year. So at this point we would expect to be pretty fully invested in terms of our capital base. The unknown would be payoffs that we’re not aware of but you can know one that’s for about $10 million so far.

Dennis Robert Dodd – Raymond James & Associates, Inc.

Okay, thank you.

Robert T. Ladd

Thank you, Robert.

Operator

(Operator Instructions) We go next to Chris Kotowski with Oppenheimer.

Chris M. Kotowski – Oppenheimer &Co.

Yes, good morning. If we did our math right, it looks like gross interest income was down slightly on the quarter basis. You know the investment for us. Can you describe what happen there, was that non-accrual or just margin pressure?

Robert T. Ladd

It wasn’t a non-accrual because that one on non-accrual and the first quarter, so we had in nearly in January that’s right, that’s right, Chris. So we had net investment income that we’ve got, not just interest. For the fourth quarter it was about $7.4 million, and your total net investment income was $7.7 million. So we had some fees in there as well. And I don’t have it currently what it was for the third quarter.

Chris M. Kotowski – Oppenheimer &Co.

Okay, thanks.

Robert T. Ladd

It’s a up flow in the [indiscernible].

Chris M. Kotowski – Oppenheimer &Co.

Yeah, okay, thanks. Yes. Okay and the other question I have is this was the last quarter where you’re fee waiver is active, I believe right for the dividend. And I am just wondering what is your philosophy on the dividend going forward, if investment income were below the run rate of the dividend would you payout what net investment income is or you dedicate it to keeping the core dividend where it is?

Robert T. Ladd

So, ultimately of course the dividend policy would be subject to the board’s decision, but we, as we stated our objective is to run this business where we are earning e dividends that we are paying out. I think we will certainly look at that not just every quarter, but over a years time period, but that’s the approach that will take. So there maybe a quarter that we don’t fully covered and then maybe quarter to only more than covered, but I think we’ll look at it overtime, but that’s certainly one of our goals is that we run the business in that way.

Chris M. Kotowski – Oppenheimer &Co.

Okay. And then the only other thing I had was just the gross investment income just, I mean it looked like it’s takes down by our map like $200,000 or so. And just in a quarter that’s a little surprising given the growth that you have in the portfolio?

Robert T. Ladd

Yeah, it’s had. I don’t really know, right now being up in crystal. One, we will keep on going and I’ll come back on or before the end of the car. Let you now. I think it’s likely because just I mentioned it’s likely it’s of just a little bit that one variable would be the fee income that’s taken in the quarter. And as I recall in the third quarter we had more fee income, which were related to payoffs et cetera. So, there is nothing and I’d say there is noting in the business and the portfolio that would have caused that to be significantly different.

Chris M. Kotowski – Oppenheimer &Co.

Okay, thank you.

Robert T. Ladd

Thank you. You’re welcome.

W. Todd Huskinson

Thank you.

Operator

(Operator Instructions) Mr. Ladd, there are no other questions at the moment sir.

Robert T. Ladd

Okay, thank you very much. Thanks everyone for joining us and we look forward to speaking with you in about 90 days. Take care, bye bye.

Operator

Ladies and gentlemen that concludes today’s conference. Again thank you everyone for joining us.

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