Private Credit Expansion And Floating Rate Loans Are Expected To Support Earnings Durability

Catalysts

About Stellus Capital Investment

Stellus Capital Investment Corporation provides private credit solutions to lower middle market companies, primarily through secured, floating rate loans, often alongside equity co investments.

What are the underlying business or industry changes driving this perspective?

• Expansion of the private equity ecosystem and sponsor backed deal flow supports a durable pipeline of new originations and add on financings, which may influence asset growth and interest income and revenue.
• A continued shift by smaller and mid sized companies toward private credit financing rather than traditional banks, especially for sponsor led transactions, positions Stellus to focus on maintaining deployment levels and stabilizing or growing earnings.
• A high proportion of secured, floating rate loans with conservative leverage structures and strong covenants is intended to help preserve credit quality through cycles, limit credit losses and support consistent net margins.
• Ongoing equity co investments and a schedule of realizations, including anticipated gains in late 2025 and early 2026, may provide additional potential upside beyond coupon income and can influence total earnings and return on equity.
• Incremental balance sheet capacity from the upsized revolving credit facility and the expected third SBIC license, combined with reduced funding spreads and term extended to 2030, is expected to lower average cost of capital and affect net investment income growth.

Assumptions

How have these above catalysts been quantified?

• Analysts are assuming Stellus Capital Investment's revenue will grow by 2.0% annually over the next 3 years.
• Analysts assume that profit margins will increase from 29.8% today to 30.7% in 3 years time.
• Analysts expect earnings to reach $33.3 million (and earnings per share of $1.13) by about December 2028, up from $30.5 million today. However, there is some disagreement amongst the analysts with the more bearish ones expecting earnings as low as $30.0 million.
• In order for the above numbers to justify the price target of the analysts, the company would need to trade at a PE ratio of 17.5x on those 2028 earnings, up from 11.5x today. This future PE is lower than the current PE for the US Capital Markets industry at 23.8x.
• Analysts expect the number of shares outstanding to grow by 5.19% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 9.79%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• Intensifying competition in private credit is already compressing loan spreads from roughly 6 over SOFR to just under 5 over SOFR. If this trend continues while funding costs stay elevated, Stellus could see pressure on net investment income and net margins.
• A meaningful 18 percent of the portfolio is already marked as not meeting plan or expectations and loans to 5 portfolio companies are on nonaccrual. Any cyclical downturn or sponsor underperformance could trigger higher credit losses, further unrealized losses and lower earnings.
• Regular issuance of equity through the ATM program combined with potential additional equity to fund a third SBIC license increases the share count over time, which could dilute per share earnings and net asset value if portfolio returns do not step up accordingly.
• Ongoing repayments and expected significant payoffs in the fourth quarter, partly driven by company sales and refinancings into cheaper bank debt, may outpace Stellus deployment opportunities in a tighter spread environment. This could limit portfolio growth and constrain revenue and earnings expansion.
• Maintaining dividend payments above current period earnings in order to distribute spillover income reduces balance sheet flexibility. If not offset by stronger realizations and loan yields, this could lead to continued net asset value erosion and weaker long term return on equity.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The analysts have a consensus price target of $13.1 for Stellus Capital Investment based on their expectations of its future earnings growth, profit margins and other risk factors.
  
• In order for you to agree with the analysts, you'd need to believe that by 2028, revenues will be $108.7 million, earnings will come to $33.3 million, and it would be trading on a PE ratio of 17.5x, assuming you use a discount rate of 9.8%.
  
• Given the current share price of $12.11, the analyst price target of $13.1 is 7.6% higher. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.