Business context and reporting period
Stellus Capital Investment Corporation is an externally managed business development company (BDC) investing primarily in debt and equity of U.S. middle-market companies. This Form 10-Q covers the quarter and nine months ended September 30, 2022; comparisons are with the corresponding 2021 periods. The portfolio comprised 89 companies at quarter-end, up from 73 at December 31, 2021.
Financial performance and position
| Metric | Q3 2022 | Q3 2021 | Nine months 2022 | Nine months 2021 |
|---|---|---|---|---|
| Investment income | $20.1 million | $17.0 million | $51.7 million | $46.1 million |
| Net investment income | $7.2 million ($0.37/share) | $4.1 million ($0.21/share) | $18.9 million ($0.97/share) | $14.7 million ($0.75/share) |
| Net increase in net assets from operations | $4.0 million ($0.20/share) | $12.8 million ($0.66/share) | $10.5 million ($0.54/share) | $23.3 million ($1.20/share) |
| Distributions per share | $0.34 | $0.58 | $0.96 | $1.08 |
Net investment income was approximately 35.7% of investment income in Q3 2022 versus 23.9% in Q3 2021, and 36.5% versus 31.8% for the nine-month periods. These are calculated ratios, not company-reported margin measures.
At September 30, 2022, total assets were $889.1 million, liabilities $611.9 million, net assets $277.2 million and NAV $14.18 per share, versus $285.1 million and $14.61 per share at December 31, 2021. Investment fair value was $871.7 million against cost of $899.1 million. Cash and cash equivalents were $12.4 million, down from $44.2 million at year-end.
Debt included $100.0 million principal of 2026 notes, $199.0 million outstanding under the credit facility and $306.0 million of SBA-guaranteed debentures; balance-sheet debt amounts are presented net of unamortized financing costs. Asset coverage was 193% at quarter-end, versus 203% at year-end. The company reported compliance with credit-facility covenants.
For the nine months, operating cash use was $92.6 million, primarily reflecting investment purchases; financing provided $60.9 million, mainly from SBA debentures and net credit-facility borrowings. Cash declined by $31.8 million. Portfolio debt yield was 9.8%, up from 8.0% at year-end, and 97% of debt investments were floating-rate.
Material changes versus prior comparable periods
- Investment income rose 18% in Q3 and 12% for the nine months, primarily reflecting portfolio growth and higher rates. Net investment income increased 77% in Q3 and 29% for the nine months, despite higher financing costs.
- Operating expenses were approximately flat in Q3 but increased to $32.9 million from $31.5 million for the nine months. Interest expense and other fees rose to $16.9 million from $13.9 million for the nine months; the credit facility’s weighted-average rate was 3.8% versus 2.8% in the prior-year period.
- Operations were reduced by unrealized investment depreciation of $4.8 million in Q3 and $12.8 million for the nine months, compared with unrealized appreciation of $2.1 million and $3.9 million, respectively, in 2021. Management attributed depreciation to realization-related reversals and wider credit spreads and swap rates.
- Portfolio fair value increased from $772.9 million at year-end as investment purchases exceeded repayments, but aggregate unrealized depreciation widened. Investment-category ratings also shifted: category 1 increased to 18% of portfolio fair value from 8%; category 4 increased to 3% from 1%; category 5 was zero by fair value, though two companies remained in that category.
- Non-accrual loans increased to four from three, representing 5.5% of loan cost and 2.5% of fair value, versus 4.2% and 0.8% at year-end.
Outlook, risks, contingencies and unusual items
The filing provides no numerical earnings or investment guidance. Management says economic activity continued to accelerate, while highlighting supply-chain disruption, labor shortages, commodity inflation, rising rates, geopolitical instability and market volatility. It also discusses continuing uncertainty from COVID-19 and its potential effects on portfolio company performance and valuations.
Higher rates can support income because most debt investments float, but also increase funding costs and may pressure borrowers. The filing estimates that a 100-basis-point rate increase would raise annual interest income by $7.8 million and interest expense by $2.0 million, for $5.8 million higher net interest income, before incentive-fee effects and other changes. Most portfolio investments are Level 3 fair-value estimates, making valuations subject to significant judgment.
Management states available cash and credit-facility capacity were sufficient to fund approximately $30.3 million of unfunded commitments. The facility has a $265 million committed limit, a possible increase to $280 million, and a $10 million minimum-liquidity covenant; the company reported compliance. Legal proceedings were not expected to have a material effect. No material risk-factor changes were reported, apart from the filing’s additional disclosures.
Four loans were on non-accrual at quarter-end: Grupo HIMA San Pablo, Protect America, General LED and NuMet Machining Techniques. HIMA and Protect America were carried at zero fair value; NuMet entered non-accrual in April 2022. Unaccrued income on non-accrual investments was $6.2 million. Separately, the company declared regular monthly dividends of $0.0933 and additional dividends of $0.02 per share for each of October, November and December 2022. Subsequent events included a $5.0 million first-lien loan investment in NINJIO, a $1.16 million realization of EC Defense equity with a $0.95 million realized gain, and a $206.8 million credit-facility balance as of November 3, 2022.
Most important facts for investors to verify
- Whether the portfolio’s Level 3 marks and the $12.8 million nine-month unrealized depreciation adequately reflect worsening credit conditions.
- Performance, recovery prospects and accrued-income treatment for the four non-accrual borrowers, including the zero-fair-value HIMA and Protect America positions.
- How rising benchmark rates affect portfolio borrowers, interest income, borrowing costs and dividend coverage.
- Liquidity headroom after the decline in cash, the approximately $30.3 million in unfunded commitments, and credit-facility covenant requirements.
- Whether net investment income and taxable income sustain declared distributions; reported distributions were $0.96 per share versus nine-month NII of $0.97 per share.
- Changes in NAV, leverage and credit-facility utilization, as well as the effect of market prices trading below NAV on future equity issuance.