Stellus Capital Stock: 12% Yield, Monthly Payer, Reasonable Valuation (NYSE:SCM)

Stellus Capital Investment Corporation (NYSE:SCM) offers passive income investors a highly hedged 12% dividend yield, which is paid out in monthly installments.

The business development company has had a fairly stable dividend payout ratio over the past twelve months and Stellus Capital Investment generated a solid amount of new investment in the last quarter.

SCM pays passive income investors a robust yield, and while BDC has seen its non-accrual ratio increase over the past six months, I think the value proposition is good enough for a ‘Buy’ rating.

My rating history

I modified my stock rating on Stellus Capital Investment from “Hold” to Buy in June as we saw an opportunity for passive income investors to buy BDC stock during the June correction.

I continue to rate the business development company a “Buy” when given its low NII-based dividend payout ratio of 80%, and I think the overweighting of First Liens makes SCM compelling as a high-quality investment as well.

Portfolio analysis, new origins, credit quality

Stellus Capital Investment is a small business development company with total investments of just $900 million. Most of these assets were Senior Secured First and Second Liens, the first group of assets representing 90% of all investments measured at fair value.

The portfolio also included minor investments in Second Liens, Unsecured Debt and Equity, but Stellus Capital Investment is largely concentrated in secured First Liens.

Like other business development companies in the sector such as Ares Capital Corp. (ARCC) or Blackstone Secured Lending Inc. (BXSL), Stellus Capital Investment enjoyed a strong quarter in terms of new investment.

Stellus Capital Investment added to its portfolio in the second quarter with new investments: BDC had net investment activity of $25.6 million, net of redemptions, compared to a decrease of $2.7 million in the first quarter.

Stellus Capital Investment has seen credit quality deteriorate over the past two quarters though, which is a negative I’d like to mention here.

BDC had a non-accrual fair value ratio of 2.9% at June 30, 2024, compared to 2.1% at March 31, 2024 and 1.3% at December 31, 2023.

Stellus Capital Investment currently has five non-accrual loans, up from four in the previous period quarter. Despite jobless growth, I’m not changing my rating on the stock, mainly because of SCM’s large margin of safety on the dividend.

In terms of Stellus Capital Investment’s NII performance, the BDC fared well despite a non-accumulating rate increase. In the second quarter, Stellus Capital Investment earned $11.8 million in net investment income, primarily in the form of interest income from unrelated investments, reflecting a 13.2% increase over last year.

What matters most to me as an income oriented investor is a high degree of excess dividend coverage, which SCM continues to deliver.

Dividend payment and yield opportunity

Stellus Capital Investment earned $0.50 per share of net core investment income in the third quarter, compared to a total dividend of $0.40 per share. However, this dividend is paid monthly to passive income investors. The dividend payout ratio last quarter was 80% and has been fairly stable over the past year.

Over the past twelve months, Stellus Capital Investment has paid out just 83% of net underlying investment income, which makes the dividend relatively safe in my view, even if the central bank cuts interest rates next month. At a current share price of $13.75, shares of Stellus Capital Investment are yielding 11.6%.

3% premium to the net asset value

Stellus Capital Investment’s net asset value as of June 30, 2024 was $13.36, reflecting a quarter-over-quarter decrease of $0.05 per share. I value a business development company primarily from a NAV angle because it provides a sensible estimate of the value of a BDC’s underlying net assets.

The companies I compare Stellus Capital with are Ares Capital Corp., Golub Capital BDC Inc. (GBDC) and Blackstone Secured Lending, all of which also have dominant positions in the First Lien portfolio and all of which cover their dividends well with net investment income.

Stellus Capital Investment sells at a 3% premium to NAV, making BDC cheaper than some of its peers. That being said, however, all of the BDCs referenced here have better credit profiles (lower non-accumulation rates).

What risks should passive income investors consider?

Stellus Capital Investment holds a portfolio of variable rate loans (98% of the portfolio) that are poised to produce lower interest income (and therefore lower net underlying investment income) if the central bank cuts term interest rates short next month, which is likely.

This implies that the business development company could see its dividend payout value deteriorate, which in turn could lead to a less well-covered 12% dividend yield for passive income investors .

My conclusion

Stellus Capital Investment is a solid “buy” for passive income investors who appreciate a BDC that has developed a distinctive First Lien approach to middle market investing.

Stellus Capital Investment covers its dividend very well with net income from underlying investments, and while BDC does not increase its dividend payout, the dividend has a large margin of safety and its portfolio is growing.

The no-accumulation situation has deteriorated over the past six months, which is negative, but the dividend, as I said, does not appear to be in danger at present.

The net asset value premium is very moderate at 3% and I think the 12% yield is very sustainable. Buy.