Stellus Capital Stock: 8.2% yield, why wait when you can get paid now (NYSE:SCM)
Capital appreciation is nice, but sometimes investors just want to get paid now. This is why it may make sense to hold higher yielding asset classes such as REITs, MLPs and BDCs. Indeed, these asset classes were designed for high returns, as they do not have to pay corporate-level taxes as long as they distribute 90% of their taxable income.
Since the majority of REIT and BDC dividends are taxable at ordinary income rates, it makes sense to hold them in traditional IRAs and Roth IRAs, and that’s what makes them a favorite among retirees and aspiring retirees.
This brings me to BDC, Stellus Capital Investment (SCM), which pays an attractive high yield that may be appealing to income investors. This article highlights what makes SCM a potentially good buy right now, so let’s get started.
8.2% return, why wait when you can get paid now
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 $7 billion in more than 290 companies.
Currently, SCM’s portfolio consists of 75 well-diversified active investments, with low exposure to the cyclical retail and energy sectors. As shown below, Business Services, Healthcare, Aerospace & Defense, Media and Capital Goods make up the top 5 sectors of SCM, accounting for 55% of the fair value of the portfolio.
SCM focuses on originated lending as opposed to largely syndicated financing. This makes Stellus the sole lender in many cases of its portfolio companies. This direct relationship with borrowers familiarizes SCM management with its portfolio companies and, as an incumbent, positions SCM well to conduct follow-on financings.
Stellus has a conservatively structured portfolio, with 89% of its loan investments being senior secured debt, and the remaining 8% and 3% being junior secured and unsecured debt, respectively. This puts SCM in a relatively safe position to recover its capital if a borrower defaults on its financial obligations.
This model has proven successful for SCM, as evidenced by the cumulative distributions of $12.27 paid to shareholders since the IPO. This means that shareholders at the IPO have almost recouped all of their capital through dividends, based on the IPO price of $15 per share. As shown below, SCM has maintained a relatively stable net asset/share value since inception, with a strong rebound since the start of 2020.
The quality of SCM’s portfolio also continues to improve, with the weighted average risk score increasing from 2.03 at the end of 2019 to 1.92 (on a scale of 1 to 5, with 1 being the lowest risk) in the third quarter of 2021. accrued liabilities also appear manageable, representing only 1.1% of the fair value of the portfolio.
Going forward, SCM is well positioned to withstand higher interest rates as 95% of its loan portfolio is floating rate (compared to 93% floating rate at the end of 2020). SCM also maintains the ability of its balance sheet to fund additional lending, as it has a regulatory leverage ratio of around 1:1, well below the regulatory limit of 2:1.
Management also sees opportunities to recycle capital and tabulates its second SBIC debenture, as shown below during its recent conference call:
What’s happening now, just because of the large refunds we’re getting, both in our SBIC licenses as well as our regular weight capital at BDC, [we have] lots of opportunities to recycle capital. So I think you’ll see us continue to grow over the next year, but we’ll be funding many of the new opportunities with refunds only.
And then I would say, certainly, that we intend to fully exploit the second license debentures. We currently have $100 million drawn against a potential $175 million. We therefore intend to draw the balance probably during the coming year. And eventually, we may have the ability to raise additional equity. And to maintain our overall leverage profile, we would add leverage to that.
Meanwhile, SCM’s current quarterly dividend rate of $0.28 is covered by its basic net investment income of $0.31 in its last reported quarter. SCM should also be able to maintain its $0.06 in additional quarterly dividends, as it had $21M in payout at the end of Q3, which equates to $1.07 per share, based on 19.5 M shares outstanding at the end of September (although the recent increase in November would have reduced indirect income per share).
Risks to SCM include its external management structure, which may lead to conflicts of interest, since management receives part of its compensation based on assets under management. In addition, increased competition for transactions may result in yield compression, and BDC’s portfolio companies are generally sensitive to adverse economic events.
I see value in SCM given all of the above at the current price of $13.58 with a price-to-book ratio of 0.96. I consider a stock price premium to net asset value with a price-to-book ratio of 1.0 to 1.1x to be deserved given the company’s track record of maintaining value net asset/stable share as well as accrued dividends paid.
Analysts on the sell side have a consensus buy rating with an average price target of $14.90. This implies a potential total return of 18% over one year, including dividends.
Key takeaway for investors
Stellus Capital Investment has a conservatively managed portfolio comprised primarily of senior secured loans. It has a strong track record of preserving its net asset/share value and its accrued dividends paid approximate its IPO price.
Looking ahead, SCM has opportunities to recycle capital as well as balance sheet capacity to grow its portfolio. Finally, SCM’s dividend is covered by NII and I see value in the reduction in share price relative to NAV.