Stellus Capital: Outlook Is Gloomy; Consider Other Options (NYSE:SCM)

Stellus Capital Investment Corporation (NYSE:SCM) is one of the business development firms suffering above-average credit losses. Furthermore, the rising number of outstanding shares, combined with potential rate cuts, could also have a negative impact on its earnings per share and dividends per share. Therefore, the company’s returns are probably going to face pressure in the second half and the following year in my view. Additionally, the recent share price selloff does not seem to be a buying opportunity, and investors may consider other BDCs that provide higher returns with a lower risk level.

So Far Growth Trends look Strong

Stellus Capital has generated robust share price and dividend returns over the last three years, thanks to favorable market conditions and solid financial growth. Its total return of 140% includes an 80% price appreciation and a 60% dividend return.

Its returns were completely backed by financial growth. Moreover, the robust net investment income growth trend that started last year intensified in the first half of 2023. Its NII of $50.6 million in the first half of 2023 increased significantly from $31.6 million in the same period last year. What’s more, despite a 43% dividend increase to $0.40 per share, its NII per share of $0.46 in the first quarter and $0.49 per share in the second quarter exceeded the quarterly dividend. On the other hand, the company has steadily increased its portfolio value in the past years. As of the end of June 2023, its portfolio value was at $882 million compared to $772 million at the beginning of 2022.

But The Outlook Appears Gloomy

As past performance is never a guarantee of future success, it appears that Stellus Capital may face challenges in extending the investment income growth trend in the second half and the following year. There are a couple of reasons to believe that the company will struggle to maintain the growth momentum and that things might get tighter quarter over quarter.

For instance, the latest results show that Stellus has been experiencing above-average non-accruals and unrealized losses. It recorded $6.3 million in unrealized loss in the June quarter while 3.3% of its overall portfolio was on non-accruals compared to the industry median of 1.3%. Non-accruals at 3.3% mean that $29 million in fair-value investments have stopped paying interest. Furthermore, 13% of the portfolio’s holdings were rated as third- or fourth-grade investments. Investments in the third category have not yet missed interest or principal payments but are considered highly risky. Whereas, investments in the fourth category have missed interest payments. Stellus Capital’s CEO stated during an earnings call that the company intends to offset losses by realizing gains on equity investments, with plans to invest in its top-performing existing portfolio companies.

In addition to the impact of credit losses, the company’s strategy of raising funds through equity offerings is likely to create a negative impact on its net asset value, earnings per share, and dividend per share. Stellus issued 2.3 million shares in the last quarter, increasing the total outstanding shares count to 22.57 million. Credit losses and increased outstanding shares have already begun to have an impact on financial metrics. For instance, the company ended the second quarter with a net asset value of $13.67 per share down from $14.02 at the end of 2022. If Stellus had kept its outstanding shares at the December 2022 level, its NAV would have been around $15.50 per share.

On the other hand, the company’s floating rate portfolio could also suffer when rates begin to fall in 2024. The CME FedWatch Tool predicts no more rate hikes in the second half of the year, with a couple of cuts in 2024. According to Wall Street estimates, Stellus Capital’s earnings are unlikely to increase in the second half of 2023 when compared to the first half, and the deceleration trend will accelerate in the coming year. Although there is no risk to the company’s dividend in 2023, more credit losses, negative net investment income growth and a higher number of outstanding shares point to limited dividend growth potential in 2024. Furthermore, when key financial metrics show negative growth, share price performance suffers. Therefore, I also expect a limited upside for Stellus Capital’s stock price.

Quant Rating and Alternatives

Stellus Capital earned hold ratings based on SA’s quant ratings. A low grade on earnings revisions contributed significantly to its overall quant score. Wall Street analysts have reduced their earnings forecast for the company due to concerns I discussed in detail above. Furthermore, the poor momentum score also contributed to a hold rating. So far in 2023, the company’s shares have surged 6% compared to the S&P 500’s gains of around 15%. Although it received a negative B on the growth factor and a negative A on profitability, I anticipate a drop in ratings for both factors because profitability and growth are expected to turn negative in the coming quarters. Stellus Capital is currently ranked 67th out of 95 in the quant industry ranking.

There are a number of BDCs with lower credit risk and higher earnings growth potential. For instance, Horizon Technology (HRZN) is well-positioned to offer a healthy base plus special and supplementary dividends. According to the SA quant ranking, it is ranked ninth in the industry. Click here to read in detail about Horizon Technology. Furthermore, with non-accruals around only 0.4%, MidCap Financial (MFIC) could also be a solid option in the BDC space. It received a strong quant buy rating, with a high rank in the industry. Click here to learn more about MFIC.

In Conclusion

Stellus Capital has a long history of providing shareholders with strong returns. Despite forecasted financial and credit deterioration, its quarterly dividend of $0.40 appears completely safe. However, there is a risk to its dividend growth potential and share price appreciation. Meanwhile, a large number of its industry peers are in a position to offer special dividends along with base dividends. Therefore, instead of chasing struggling Stellus Capital for market-beating returns, it may be prudent to consider other appealing BDC options.