ArrowMark Financial Corp. (BANX) Q4 2015 Earnings Report, Transcript and Summary

Welcome to the StoneCastle Financial Corp. Q4 2015 Investor Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. Now, I would like to turn the call over to Rachel Schatten, General Counsel of StoneCastle Financial. Thank you, please begin.

Good afternoon. Before we begin this conference call, I’d like to remind everyone that certain statements made during the call maybe considered forward-looking statements based on current management expectations that involve substantial risks and uncertainties. Actual results may differ materially from the results stated in or implied by these forward-looking statements. This would depend on numerous factors such as changes in securities or financial markets or general economic conditions, the volume of sales and purchases of shares of common stock, the continuation of investment advisory, administrative and service contracts, and other risks discussed from time to time in the company’s filings with the SEC including annual and semiannual reports of the company. StoneCastle Financial has based the forward-looking statements included in this presentation on information available to us as of December 31, 2015. The company undertakes no duty to update any forward-looking statement made herein. All forward-looking statements speak only as of today, February 25, 2016. With this housekeeping out of the way, I will turn the call over to StoneCastle Financial’s Chairman and Chief Executive Officer, Josh Siegel.

Thank you, Rachel. Good afternoon. And welcome to StoneCastle Financial’s fourth quarter 2015 investor call. In addition to Rachel, joining me today are George Shilowitz, the company's President; and Pat Farrell, our Chief Financial Officer. I would like to start the call today by reviewing the company's fourth quarter investment in the preferred shares of the community funding CLO transaction and how it affect the fourth quarter earnings on a GAAP basis. Following that, I would like to review StoneCastle Financials quarterly results and our investment activity and then turn the call back over to Pat, who'll provide you with greater detail on our financial results before I open up the call for questions. On October 15, 2015, StoneCastle Financial purchased 45.5 million of preferred shares issued by community funding. And what is sometimes referred to as a bank credit securitization or full transaction. In order to fund this purchase, StoneCastle Financial contributed nine securities from our investment portfolio valued at 45.4 million, with the remainder paid in cash. Community funding raise capital from the 45.5 million of preferred shares purchased by StoneCastle Financial and 205 million of single A rated senior notes sold to institutional investors. Community funding use these proceeds to invest 250 million into a well-diversified portfolio comprised predominantly of subordinated loans in 35 community banks and bank holding companies through 24 states. The single largest region, the MidWest totaled 36% and the single largest state exposure was Missouri at 10%. A full list of the banks within this transaction can be found in our 2015 annual report. Community funding's revenues are generated from the 250 million pool of collateral which has an approximate annual fixed rate yield of 7%. That income is used to pay three types of expenses. Administrative expenses of approximately 5 basis points per annum on the amount of collateral, interest expense on the 205 million of senior notes, set initially at 5.75% and increases to 6.4% after year five. And a servicing fee of 10 basis points per annum on the amount of collateral. The servicing fee which is paid to StoneCastle investment management is currently being rebated in its entirety to StoneCastle Financial. After all these expenses are paid, StoneCastle Financial as the owner of the preferred shares is entitled to receive all of the remaining cash flows each quarter. We currently estimate the effective yield of the preferred shares to be 10.49%. Now, I would like to review the overall results for this past quarter. And I'm pleased to report that in the fourth quarter, StoneCastle's total income increased from the prior quarter, our ninth consecutive quarter, the increase since the inception of the company. Net investment income for the quarter was approximately 2.7 million or $0.42 per share, a 15% increase from last quarter. As I mentioned earlier, StoneCastle contributed securities as part of the payment for the community funding preferred shares. Upon contribution of the assets, StoneCastle intentionally realize a loss of 2.4 million due predominantly to a change in the interest rate of some of the securities that occurred upon transfer. The taking of this 2.4 million loss was required in order to create the 45.5 million of 10.49% yield in preferred shares we purchased. This investment should generate 980,000 of incremental interest income each year for the next 10 years. Therefore in the fourth quarter the company had a net realized capital loss of approximately 3 million, resulting in the company's net asset value per share decreasing by $0.47 to $21.62 at year end. Now I'd like to move on to discuss the broader portfolio. During the quarter StoneCastle Financial invested 85.4 million in 14 investments. These investments were offset by issuer calls or repayments of 42.2 million from six investments, and sales proceeds of 51.2 million from 14 investments. Nine of the 14 sales were assets contributed to community funding and two of the issuer calls were related to banks they called their securities away from StoneCastle, in order to receive funding from the CLO. At year end, the largest asset categories in the invested portfolio were as follows. 38.7% in preferred and convertible preferred stocks, 25.2% in trust preferred securities and 24.3% in preferred shares of the bank credit securitization. The remaining 11.8% of the portfolio is comprised of term loans, debt securities, common stock, and other securities. The quarter end schedule of investments can be found on the company's annual report and on the company's website. In order to put these various asset categories into context, I would like to describe where these investments reside relative to the entire capital structure of a typical bank. StoneCastle Financial owns very little common equity in community banks and is typically not the first investor to take losses if the bank becomes distressed. Most of our holdings, particular preferred stock and subordinated debt rarely represent a first or second loss position to credit events in banks portfolio of loans. First, the borrower on a loan would lose their equity. Second, the bank would utilize its loan-loss reserves. Third, the bank would charge off loan losses which would first impact the common stock of the bank through a loss of retained earnings. Credit impacts to preferred stock or subordinated loans typically occur after other parties have incurred losses. A significant number of StoneCastle Financials underlying assets and specifically those within the securitization are senior in priority to trust preferred securities, TARP, SBLF, preferred shares and common shares. Our focus on credit quality within the underlying banks in the pool as well as the invested portfolio, has differentiated StoneCastle Financial from other income vehicles in the marketplace. Within the community funding asset pool, roughly 97% of the banks received investment credit equivalent credit score by core ratings and approximately 91% received an investment grade credit score from Moody’s RiskCalc. The banks that were not investment grade, was scored BB equivalent. Within the entire StoneCastle Financial portfolio, a majority of our assets were scored triple B minus or better backlog. As of year-end, StoneCastle Financials invested portfolio continued to have no charge offs and no impaired assets. While we recognize investors' concern about energy related issues on the share price of all banks, we have very few community banks with measurable exposure to energy. So while energy related credit issues maybe impacting other companies, it is not a primary concern for us at this time. Stone castle financial has invested in what we believe to be a portfolio of healthy community banks with the steadfast pursuit of credit quality. We believe that investors should focus on the underlying credit quality of our assets relative to our share price, that’s nearly 30% discount to NAV at the time of this call. Now I want to turn the call over to Pat Farrell to discuss the financial results and provide details on how we believe investors can better understand the underlying value of the company and the disconnect between market value and asset value.

Thank you, Josh. As I do each quarter, I will present the financials by going through the detailed components to help you understand the value of the company. The net asset value at December 31th was $21.62 per share. The NAV for StoneCastle Financial comprised of four components: net investment income, realized gains and losses, the change in value of the portfolio's investments, and finally, distributions paid during the period. Let me walk through these components. Net investment income for the quarter was $2,749,738 or $0.42 per share. Net investment income reflects gross income from dividends and interest received from our portfolio investment minus operating expenses. Gross income for the fourth quarter was $4,482,779 or $0.69 per share. Gross income investment was up 9% from last quarter. I would like to note that origination fee income increased approximately 660,000 into a one-time acceleration of fee income associated with the securities contributed to community funding. The company's operating expenses are comprised of advisory fees which are now occurring at the full contractual rate, interest expense related to our use of leverage custody and administration fees, legal fees, ABA fees, and other expenses. Operating expenses for the quarter were $1,733,041 or $0.27 per share. Total expenses before waivers were down from the prior quarter primarily due to a reduced use of leverage and reduced advisory fees. Expenses were also lower due to the reduced ABA fee which was in effect for the full quarter. The realized gains and losses reflect securities which were sold or called during the quarter. For the fourth quarter, this amounted to a loss of $3,005,896. The major component of this was a loss of $2,479,198 related to the contribution of 45.4 million of securities to community funding. As Josh previously mentioned, it is important to note that this one-time loss allowed StoneCastle Financial to generate approximately $983,000 additional annual income for each of the next 10 years. The third component, changes in unrealized appreciation or depreciation of the portfolio, relates to how the value of the entire investment portfolio has changed from the previous quarter-end to the current quarter-end. For the fourth quarter the value of the portfolio increased $503,005. As I note each quarter the vast majority of the portfolio is valued independently by market quotations and broker dealer quotes. The quarterly marked guidance is provided by minimum of two quotation and is a truly independent third party assessment of the current liquidation value of the portfolio. Please take a look in the 2015 annual report for more information on the evaluation of the portfolio. The fourth component affecting the net asset value, is distributions. The cash distribution for the quarter was $0.35 per share, paid on January 4th to shareholders of record on December 22nd. This reflects an increase of 6.1% or $0.02 per share from the prior quarter. In summary, we began the quarter with a net asset value of $22.09 per share. During the quarter we generated net income of $2,749,738, realized losses of $3,005,896 and the value of the portfolio decreased by $503005. Some of these components offset by distribution of $0.35 per share, resulted in a net asset value of $21.62 per share at December 31st. Now I'd like to take a moment to review the various changes in the net asset value of the company since inception in November 2013. StoneCastle Financial initial public offering price or net asset value was $25 per share. This was reduced by initial sales charges and underwriting fees of $1.51 per share in 2013 and $0.05 per share of charges related to the follow-on offering in 2014. In addition, since inception, the net asset value reflects the net investment income of $2.18 per share, net realized and unrealized losses of only $0.21 per share and total declared distributions of $3.79 per share. This results in our NAV as of December 31st, of $21.62. Looking at the results for the full year ending on December 31st, 2015, the company had gross investment income of 15.77 million and operating expenses of 6.42 million. This resulted in net investment income of $9.35 million or the $1.44 per share. The company realized net capital losses of approximately $1 million or $0.15 per share and the company paid cash distributions of $1.51 per share. At year end, the company had total assets of $192.5 million, consisting of total investments of a $184.8 million, cash of 4 million, and other assets of $3.7 million. Other assets include receivables of $2.9 million and prepared assets of approximately [$821,000] [ph]. Now let me update you on our credit facility. At December 31st, the company had $25 million outstanding from the facility. In accordance with the regulated investment company rules, we may only borrow up to 33.3% of our total assets. Our leverage percentage at the end of the quarter was 13%. However, as of today’s date, 60 million is outstanding on the facility representing 29% of total assets. Now I would like to turn it back over to Josh.

Thank you, Pat. Now operator, we would like to open the call for questions.

Thank you. [Operator Instructions] Thank you. Our first question comes from the line of Bryce Rowe. Please proceed.

Thanks, good evening. Josh and Pat, I just wanted to ask about 1) the securities payable within the balance sheet. I'm just kind of curious what does it look like and what we might see as we get to the end of the first quarter.

This is Pat. Those represented a couple of securities we had purchased but not settled at the end of the year. I think you can tell from my comment with regard to where we are with the credit facility being that we've drawn it back up to the full 60 million now, that we have made obviously a number of purchases since the end of the last quarter. So, I would expect I would not expect to see items open at the end of the quarter. Obviously, we don't know we're going to purchase between now and the end of the quarter, but assuming everything settles on time, which we always hope it does, I wouldn't expect to see anything there.

Okay. And Pat, any color around the nature of the securities? Are they more proprietary originated investments or are they more second secondary market type purchase?

No. At quarter end, those would have been a primary market. First, I should say secondary market, not something that we originated.

Okay. And then just another follow-up, Josh. The preferred that you guys originated in the quarter. Just maybe some color around that, I know that up until now you've kind of struggled to be able to book preferred and purchase some preferred. So, just curious how this kind of came about and the timing of then coming in here in [fourth] [ph] quarter.

Sure. So, just to be clear, there are two types of preferred. So, there is a bank issued DRD QDI preferred, which is Tier 1 or additional Tier 1 instrument. The preferred shares of community funding, those are preferred shares in name but they are really ordinary income representing the excess cash flows between the portfolio of loans to banks and the debt used to finance that portfolio. So, those are preferred shares of a securitization, but they are not DRD QDI. That said, there is still interest from a number of banks, I can think of two that I can't disclose the names, that are interested in preferred, because they do need additional Tier 1 capital at their holding company. So, we are continuing to see some preferred new way issuance is coming through the door. They are still disproportionately less than either senior debt or sub debt; but they still do show up.

And Josh, I was referring to the First Reliance Universal and the SNM that you outlined in the press release. Those, I assume are just secondary market purchases of --.

Those -- correct. Usually when you see the series A 9% that's TARP. Remember, all of TARP is 9%. So, those are simply sourced secondary purchases.

Okay. And the origination fee income for the quarter, is as Pat you stated that was accelerated given the contribution into community funding?

Correct. Yeah, the nature suggest, the nature of those is under GAAP. When you receive and upfront fee on a preferred stock, when the preferred stock is perceptual, GAAP has you record the increment immediately because there is no period upon which to amortize that. When we are doing a 10 year loan or a 10 debt to a bank, GAAP requires you to amortize that upfront fee across the 10 years. But when you sell a security that had an amortizing upfront fee schedule tied to it, you have to accelerate that and take it upon the time of sale.

Yeah, okay. Thank you. Sure.

Thank you. Our next question comes from the line of Chris Testa with National Securities Corporation. Please proceed.

Hi, good afternoon. Thanks for taking my question. Just a question on the evaluation fee that pop on the income statement this quarter. Is that mostly due to, is the increase now mostly due to the CLO transaction?

No. We use various pricing services for our evaluation. So, that really just has to do with our year-end services that we use from our providers, nothing directly related to the CLO in anyway.

Okay. And with the 980,000 and incremental interest income you cited from the CLO transaction, how does that -- could that just be first five years while you are at the lower rate before it steps up to a 7%?

No. It's a good question, though. So, if we look at what we were holding before we close to the transaction, that had a portfolio yield of X, and by transforming those securities selling them into the securitization pair up with several dozen other securities, the pickup in yield was significant. So, under GAAP and very consistent with a few other non-BDC RICs that own CLO equity. The yield we're booking is the yield over the 10 year period, and that is what's required under GAAP. On a cash basis because as you correctly note, the seniors are at 575 for the first years and 640 thereafter, the cash yield in a first five years is actually significantly higher than 1049 and in the back years it will be less than 1049. That is the yield over the full 10-year period. We have to book it on a yield basis. So, that's --.

Yeah. So, the 980,000 you referenced, that's kind of the GAAP level yield method kind of what's used with the CLO, but it's not reflecting the cash that's actually growing on.

Yes Sir, that's correct.

Okay. And will there be any sort of thing line items on the income statement differentiating that or we are in this close kind of the excess cash that's not taken into account under GAAP?

No. We'll just be acquiring that item. It will just show on the interest income line item for the company.

Okay. And how do the investments closed -- at the new investment side, I should say, closed in the latter part of the quarter, should we expect more interest dividend income fall through when we end the current quarter?

Yes. We did, obviously you've seen from the numbers that our calls this quarter were significantly higher. And I guess historically we've seen the fourth quarter as being the quarter with the largest amount of calls each year. Certainly that the timing of that is always difficult, depending on what's available in the marketplace. We were able to put a number of dollars to work later in the quarter and obviously we've tried to move very diligently in this first quarter to get that money invested at high rates of course. So, I think, yeah. Later in the quarter and certainly earlier in this quarter.

But one thing I would sort of be cautious of is this was a noisy quarter with the CLO, right? There was the acceleration of the upfront, there was the transfer of assets from StoneCastle Financial to the CLO, and there were purchases during the quarter. So, trying to net all those and have a view how Q1 comes from that, it'd be pretty hard to predict. What you can't take away from which we mentioned on the call, is that we are drawn to 60 million on a credit facility as of today. So, clearly we put a fair amount of money to work, but that's about as much sort of forward thinking as I can help you predict.

Okay, great. And I notice that you mentioned that you're very few times that have any sort of energy exposure which obviously is great, but how many banks would you say that you went through that are in the portfolio, that are based in the regions that have a significant amount of employment related to energy where bank customers and even if they are on a different business entirely, are still relying on those employees spending money there. Do you have an indication of that?

We do. I'll give you some general order magnitude. This clearly we do have non-public information from many of these banks, where we actually held their loan portfolios and I can't disclose that. But as an order of magnitude, if you look at the footprint of where the banks are, the one that might be in parts of Texas or Oklahoma, North Dakota, you're talking maybe 3% to 5% of the portfolio. But even within there and again I can't say it's categorical for every bank we have exposure to but one of the benefits of doing direct underwriting of specifically community banks as you can actually look in the entire loan tape and it's digestible. The number of items are actually manageable. And so, when we look through those even there they tend to be secondary or tertiary exposure. So, are they lending on oil wells? No. You don't typically have a community bank lending on oil wells. Or they may be lending on a manufacturer of widgets that is related to oil possibly. Are they lending to a barber shop that is cutting the hair of oil workers, yeah probably. But it's very far down the line in effect. From our discussions with state commissioners and the FDIC quarterly report on community banks that I think just came up within the last 48 hours. It was just resounding strength in the community bank space relative to regional money center banks. So, well that can't infer that our portfolio would never had issues. It was a confirmation of what we've seen within our portfolio which is just very good resiliency and a more conservative approach to underwriting over the last six months or year compared to what, for example, we just saw Wells Fargo today.

Great. That's great color. Thank you for taking my questions.

Sure, of course.

Thank you. [Operator Instructions] Thank you. Our next question comes from the line of Devin Ryan with JMP Securities. Please proceed.

Hey guys, this is Brian McKenna for Devin. First, I might miss this, but financing markets have been tightening across the capital structure. Are you seeing any real-time opportunities to take advantage of this, whether in originations or purchases in the secondary markets? Thanks.

That is a great question. So, if we look at what's been happening in the broader markets, yes, there is a lot of moving factors. Right? We all thought rates we're going up, now we're questioning if they're going down. You could see the 10 year has tightened quite dramatically. If we look at metrics in the financials preferred space like a PFF, as a large ETF. We've seen what might be the equivalent credit spread widening of 30 or 40 basis points. And then we look at effectively what happened to our stock over the same period, and it still was capped at 250 points. So, we're still dealing with a comparable credit risk of mostly investing great credit. So, we do find that fascinating. On the new issue market, you're not actually seeing that particularly wide. In fact, there are bank deals coming every week. So [Indiscernible] they might be 30 or 40 basis points wide to where they were six months ago, but deals that were getting done in the high fives are now just in the very low six and so. It's been a little softening but it has not capped out like you have seen high yield or other markets. So it's not creating any wind fall. Oh my goodness, it's screaming cheap, we have to get it now. We are still being prudent, we’re not actually seeing in the smaller bank names are gaping over the level.

Okay. I appreciate that. And then given that that expectation for future. It has been pushed out, how does the lower for longer rates scenario impact your portfolio? Thanks.

That's a good question. There was a study done about 20 years ago by the St. Louis Fed that looked at the correlation of bank earnings to interest rates and talked about expected interest rates and unexpected interest rates clearly I think whatever one thought was expected is now a bit unexpected. So, I don't think I'm going to go against the tide that the general view of bank earnings will probably be down slightly if rates continue to go the other direction. That said there is somewhat of a floor in most loans that banks make; LIBOR, fed funds or prime floor. So, I don't think we are going to see a whole lot of tightening of the loan yields from here. That said, we are in preferred stock or sub debt or senior debt, so whether the bank earnings are 10%, 9%, 8% or 7%, it doesn't change our yields and as long as we're not seeing credit degradation, it doesn't really change our outlook. So, I think if you are bank common stock investor, you have to be a bit wary of where rates are going right now and definitely keep an eye on credit but we like our defensive position being more senior in the capital structure.

Okay. That's it from me. Thanks for taking my questions.

Of course.

Thank you. Our next question comes from line of John Gill with BB&T Scott & Stringfellow. Please proceed.

Good afternoon. How are you all doing?

Good, how are you?

Good.

Good, thanks. In this call and in prior calls, you compared yourself to BDCs and saying that this structure is less risky, less leverage. And it should be recognized that way, but when we're looking at the discount at 30% net asset value and what I'm hearing on the call in terms of what you have done over the last six months has been really good in terms of the CLO and trying to increase the dividend. But is there anything that you are doing in order to improve the share price and decrease that net asset value discount?

Well, it's a good question. Every quarter the board discusses the dividend. We discuss items like the share repurchase program, wherein there's nothing currently on the docket. That's approving that, but I can assure you it will be a topic discussed with the upcoming board meeting, whether a buyback program or limited amount would be useful. One of the challenges we've had historically is it's one of the probably the one downside of StoneCastle Financials are volume in quite light. And so with the rules around buybacks there is so much to do. But it is something we will consider. In terms of the NAV, the BDCs aren't a very good proxy because it is a very different risk profile. It's an easy thing to think about operationally like, because we have capital. We make direct investments in companies but we are not doing leverage loans to small private companies that would otherwise be scored single B or triple C. We are not using 50% - 60% leverage. We're using 29% leverage. So, it is a very different profile. We are more akin to what might be investment grade preferred fund or investment grade financials fund. In terms of thinking about the right way but we share your frustration and all of us here are pretty substantial stock holders in the company as well. We don't really understand why we're trading at such a crazy discount. There's not much we can do to stop it, we can manage the stock price. We really work hard to manage the credit quality and the cash flows and there is nothing to really lower the NAV or raise the price we have to simply communicate as best as we can and we're going to do more of that. We will be going on a non-deal road show to communicate more. We're probably going to in the next couple of quarters, put more up on our website with some info graphics to help explain what we do a bit more. So that's as much as I can promise you we're going to try to do but I can't control the share prices. I wish I could.

Yes. I appreciate I do think that some education because I think the secondary stock offering being an overnight offering was a big mistake and is contribute to it. So, more education to get more investors to what you are doing would be helpful in my opinion.

Absolutely, complete agree.

Well, thank you very much.

Thanks.

It's our pleasure. Thank you, John.

Thank you. That is all the time we have for question. I'd now like to turn the call back over to management for closing remarks.

Well, thank you, operator. On behalf of the entire management team and our board of directors, I would like to thank you for your continued support of StoneCastle Financial and we look forward to speaking to you next quarter.

Thank you. This concludes today's teleconference. You may disconnect your lines this time. And thank you for your participation.