ArrowMark Financial Corp. (BANX) Q2 2016 Earnings Report, Transcript and Summary

Welcome to the StoneCastle Financial Corp. Q2 2016 Investor Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. Now, I’d like to turn the call over to Rachel Schatten, General Counsel of StoneCastle Financial. Thank you, Ms. Schatten. Please go ahead.

Good afternoon. Before we begin this conference call, I’d like to remind everyone that certain statements made during the call may be 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 semi-annual reports of the Company. StoneCastle Financial has based the forward-looking statements included in this presentation on information available to us as of June 30, 2016. The Company undertakes no duty to update any forward-looking statement made here in. All forward-looking statements speak only as of today, August 11, 2016. Now, 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 second quarter 2016 investor call. In addition to Rachel, joining me today is Pat Farrell, our Chief Financial Officer. I would like to start the call today with a review of StoneCastle Financial’s quarterly results and portfolio highlights, followed by comments on latest FDIC community banking industry report. Then I will turn the call over to Pat, who will provide you with greater detail on our financial results before I open up the call for questions. The second quarter was a relatively quite quarter for the company. We reported earnings in excess of distributions and an increase in NAV. There were no new credit events and we have drawn the credit line to our targeted amount. I am pleased to report that in the second quarter, StoneCastle’s net investment income was approximately $2.5 million, or $0.39 per share. The company realized losses for the quarter were approximately $139,000, or $0.02 per share. In May, the company’s board of directors elected to increase the quarterly distribution rate from $0.35 per share to $0.37 per share, an increase of $0.02 per share, up 5.7% from the prior quarter. The net asset value per share increased $0.12 to $21.21 as of June 30 with major contributor is being increases in the values of Pioneer Bankshares, Chicago Shore and Happy Bancshares. While we saw decreases in the values for Citizens Bancshares and Community Funding CLO, there have been no meaningful credit changes to these positions or any other positions in the portfolio. In June 2014, we made an investment in Pioneer Bankshares located in Dripping Springs, Texas, which is co-country on the western edge of the Austin market. We believe the bank was in a great position to grow organically and through acquisition. This past February, the bank successfully completed its previously announced merger with First Community Bank of Sugar Land, Texas, just outside the metropolitan footprint of Huston. The merger resulted in Pioneer growing from approximately $400 million in assets and five branches to over $1 billion in assets and 22 branches. Since StoneCastle made this investment, the bank has grown to become one of the largest banks in Central Texas with total deposits of $938 million. In Pioneer, we found a younger undervalued bank operating in an underserved market in a state filled with acquirable banks. With patience, intelligent and forward thinking management team, the bank has continued to grow, meeting with very little competition in the markets they are serving. The Pioneer investment is representative of how we look at and think about bank investments. The valuation this quarter reflects the increase in book value per share for the first full quarter following Pioneer’s merger. Now, I would like to move on to discuss the broader portfolio. During the quarter, StoneCastle Financial invested $22.6 million in eight investment including two new issues. These investments were offsets by a partial repayment of $2.5 million from one investment and sales proceeds of $6.4 million from four investments. During the quarter, we made a three year 7.99% term-loan investment in Bank Guam, an FDIC insured and regulated bank in Guam. At the time of our investment, this yield was nearly 700 basis points over the three year treasury rate of 1%. We also made a term loan investment in Lincoln Park Bancorp in Lincoln Park, New Jersey with a coupon rate of 8.25%. Our intension is to place the security in a future pool transaction and we believe the rate is highly attractive in the short-term as well. We believe our strong relationships in the industry as well as our flexibility in working with bank management teams were critical to closing these deals at attractive yields for both the bank and StoneCastle Financial. Our advisor, StoneCastle Asset Management, continues to manage the portfolio with a long-term strategy focused on stable income and to a lesser extent capital gains for our shareholders. Through the last several quarters, portfolio has performed with increasing consistency and we believe it is well positioned to continue generating stable income streams. In fact, the current estimated annualized yield for the portfolio is 8.97%, consistent with last quarter, and up from 8.35% in Q2 of last year. To put this figure in context, since last year, the ten year treasury has dropped about 85 basis points, yet our estimated annualized portfolio yield actually increased by about 60 basis points over the same period without moving out on the risk curve or incurring credit issues. So as of quarter end, StoneCastle’s portfolio yield of 8.97% has risen to become a credit spread of approximately 750 basis points over the ten year Treasury bill. This credit spread is relative to alternatives that are generating 350 basis points to 400 basis points for comparable credit quality and duration. Now, I’ll spend a moment on the composition of our portfolio. As of June 30, the portfolio’s asset categories as a percent of total investments were as follows: 38% in preferred stock, 23% in credit securitizations, 21% in trust preferred securities, 15% in term loans and other debt securities with the remaining 3% of the portfolio comprised of common stock and other securities. This quarter, the company sold substantially all of its sort-term liquid securities and we are fully invested as of quarter-end. The full schedule of investments can be found in the company’s SEC filings and on the company’s website. Across our assets categories and often overlooked fact is that a number of StoneCastle Financial’s underlying investments particularly subordinated debt, senior debt and term loans, ranks senior and priority to trust preferred securities, TARP, SBLF, preferred shares and common shares. These securities ranked relatively senior in the capital stack and therefore provide several structural advantages to our portfolio. For example, these securities have a lower risk of down payment because they are non-deferrable securities as opposed to common, preferred and TARP that can defer distributions. And second structural advantage is that these securities receive repayment in the event of bankruptcy or liquidation before the classes of securities just described. And third, typically valuations for these securities can be less volatile because of their seniority. These structural advantages along with the company’s strong focus on credit quality continue to differentiate StoneCastle from other income vehicles in the marketplace. We would like to remind you that the majority of the banks underlying our portfolio are scored BBB minus or better by Kroll. As a final comparison a single syndicated or exchange listed bank debt issuance with comparable credit quality to StoneCastle’s directly originated portfolio is currently yielding between 5.25% and 6.25%. However, an investor in StoneCastle Financial earns a dividend yield of approximately 7.9% inclusive of management fees resulting in a pickup of 165 basis points to 265 basis points. In addition shareholders of StoneCastle not only receive a diversified portfolio of over 100 community banks geographically spread across the U.S., but also in our opinion benefit from one of the most experienced professional investment advisors focused on bank segment credit risk. Now let me turn to the community bank industry as a whole. We have always been impressed with the history of the community bank space in this country. For nearly 80 years and throughout many varied economic cycles, this industry has provided investors with steady returns and issuer performance. Since 1992, the average annual return on equity of the community banking industry was 8.5%. As noted in the FDIC’s Q1 2016 quarterly banking profile, aggregate net income across the 5,664 FDIC insured community banks was up 7.4% from the same period last year, driven predominantly from increased revenues in net interest income and non-interest income. This increase was versus declines in aggregate net income at non-community banks of negative 2.7% over the same period. This report, which is publicly available at fdic.gov, stated in the first quarter of 2016 nearly 78% of community banks increased net interest income year-over-year and over 47% of community banks continued increase small business loans during the same period. The report also highlights stable asset quality with a non-current loan rate of 1.1%, 22 basis points lower than a year earlier all major loan categories except for commercial and industrial loans had a lower non-current rate. The C&I non-current rate was 1.2% and a net charge-off rate for community banks was 0.1% for the quarter, the lowest net charge-off rate since Q1 2006. We believe these statistics prove out of thesis from early in my career in the 1990s that community banking as an industry is resilient, diversified and consistently profitable. In addition, community banks represent an often overlooked, but highly attractive source of stable income. These convictions remain true today. Now, I want to turn the call over to Pat Farrell to discuss the financial results and provide details on the underlying value of the company.

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 June 30 was $21.21 per share, up $0.12 per from the last quarter. The NAV for StoneCastle Financial is comprised of four components: net investment income, realized gains and losses, the change in value of the portfolios investments, and finally distributions paid during the period. Let me walk through these components. Net investment income for the quarter was $2,549,219 or $0.39 per share. Net investment income reflects gross income from dividends and interest received from our portfolio investments minus operating expenses. Gross income for the second quarter was $4,260,158, or $0.65 per share. As I mentioned last quarter, Chicago Shore Bank elected to defer payments on a series A and B preferred stock. As of June 30, the accumulated dividend payment due to StoneCastle Financial on the preferred shares deferred by Chicago Shore Bank is approximately $375,000, or $0.06 per share. This dividend amount is cumulative and compounding. Under GAAP, we cannot recognize these dividends in our income until declared by Chicago Shore. Now, I would like to review the company’s operating expenses, which are comprised of advisory fees, interest expense related to our use of leverage, custodian and administration fees, legal fees and ABA fees. Operating expenses for the quarter were $1,710,939, or $0.26 per share. Total expenses were generally flat in the prior quarter. The realized gains and losses reflect securities, which was sold or called during the quarter. For the second quarter, this amounted to a loss of $139,372, or $0.02 per share. 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 second quarter, the market value of the portfolio increased by $793,787, or $0.12 per share. As I note each quarter, the vast majority of the portfolio was valued independently by market quotations and broker dealer quotes. The quarterly market value is provided by a minimum of two quotations and is an independent third-party assessment of the current liquidation value of the portfolio. The fourth component affecting the net asset value is distributions. The cash distribution for the quarter was $0.37 per share, paid on June 29 to shareholders of record on June 20. This reflects an increase of $0.02, or 5.7%, over the prior quarter. In summary, we began the quarter with a net asset value of $21.09 per share. During the quarter, we generated net income of $2,549,219, realized losses of $139,372, and value of the portfolio increased by $793,787. That some of these components offset by a distribution of $0.37 per share resulted in a net asset value of $21.21 per share at June 30. At the quarter end, the company had total assets of $201.3 million consisting of total investments of $192.4 million, cash of $4 million and other assets of $4.9 million. Other assets include receivables of $4.1 million and prepaid assets of approximately $800,000. Now let me update you on our credit facility. As of June 30th, the company had $60.75 million drawn 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 30.2% slightly above our target rate of 30%. Now, I’d like to turn it back over to Josh.

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

Thank you. [Operator Instructions] And our first question comes from the line of Devin Ryan from JMP Securities. Please proceed with your question.

Hi, thanks. Good afternoon, Josh, Pat.

Hi.

Hi.

Few questions here. I guess first just on the portfolio, so the capital has been invested, it doesn’t seem there is much in the way place orders left here, prepayment seem to have slowed. I guess the question is what’s left to optimize here in the portfolio if anything? And investment income $0.39 this quarter, the dividends $0.37, so I’m just trying to also think about the trajectory from here assuming your things are pretty stable.

Sure. So we still have a number of assets in the portfolio that are earmarked to go into a pool if and when we can do another pool. So, there are definitely assets that I mean just mathematically if we can increase their yield from where they are today even if it’s nine like a TARP piece that could turn into something that’s at 10.50 or 11 or higher we’ll pickup additional yield. So, we do think that we have room in theory for one more pool, which would rotate some of our assets both into that vehicle and out the liquidation to pickup yield. There’s not much more we can do on expenses at the moment, we can be brought that downof itas tight aswe can. So there is a bit more to go as we said from the early days, but running the math there’s a limit of course to how high it can reasonably get. And we’re not going to deviate on credit quality. So, we’re going to maximize what we have to work with.

Got it, okay. That’s very helpful. Maybe just moving on Chicago Shore, you had a positive mark-to-market this quarter, should we think about that as a positive signal around, the timing of dividend, realization of dividend payment or anything else you can update us just on that one particular investment?

Sure. We’ve seen their Q2 numbers. I would say the general trend is all public data stable to improving, OREO, other real estate owned, went down, they liquidated some things, took some – just finally took a little bit of loss on that, moved it out, but nothing trending negative. So that’s actually good. We have been in contact with the bank, while, of course, they can’t guarantee anything. They are working on addressing any of the regulatory concerns and things that they would like, which would be more capital and they’re hoping to get to that later in the year. So, their hope as they conveyed is that possibly later this year, they could come out of it, but we’ll believe it when we see it because forecasting regulators actions is notoriously hard to do.

Yes, got it, and I said okay, great. And then just last one here, we’ve seen some, some pretty big moves in short-term rates over the past month, especially three months LIBOR, I know you guys on a much floating rate, but do you have anything that’s tied to three month LIBOR. I believe the credit facility is one-year, but I just wanted to double check.

The credit facility, we have the choice right now. And since the start, we’re using one month LIBOR, just gives our view of rates has been pessimistic and not that – anyone can call rates, but we’ve been right more by luck as who the heck knows, where rates moved. Its bit of a new world we’re in. So we’ve had some negative impact, but it’s measured in the 10 basis points to 12 basis points of differential of cost. It’s not very meaningful and given that it’s a little over 0.3% of our portfolio, it really hasn’t been a driver. We do always look as every quarter both as a management team and talk to the board about interest rate hedging. At the moment still our view is probably not worthwhile, because you see the pressure on the long-end of the curve. So we have to think about a few different things with interest rates. Assets tend to price around the ten year mark, but we fund at the one month mark. So that means there’s a bit of duration issue what we have to look at. And then – so the question, are we hedging cash flows, are we hedging market value? I would imagine if we polled all of our investors, some would want one, and some would want the other. So we’re always very thoughtful about if we were to put a hedge on what exactly do we want to hedge. But rates are going to remain baffling I think for a while, I mean we all have our personal views on rates. I think our general consensus here is we don’t expect rates to go up very much, probably not this year, of course who knows. Again, the Fed has been very hard to read, but there are many both national and global reasons why I would tend to believe the rate curve stays in more of this flattening mode. And we don’t see a whole lot of upper pressure in the short-term, but we’ll have to see how that plays out.

Right, right. Yes, I guess, I was just more checking in on three months. It seems that maybe being moved by a money market reform that’s moving here, but that’s helpful. It doesn’t seem like it’s going to have a big impact on either way. So that’s great. Thank you very much.

Sure.

Our next question comes from the line of Mr. Christopher Testa from National Securities Corp. Please proceed with your question.

Hi, good evening guys. Thank you for taking my questions. Just curious you had decent originations during the quarter, just curious why the origination income was pretty light?

So the pieces that we originated were sub debt, sub loans. And under GAAP, we have to amortize that upfront over the life of the security. So with preferred stock because it’s perpetual, we get to recognize it immediately with – anything with the maturity has to be amortized over the term. So that’s why it doesn’t show up, but effectively gets built into our yield. So if you’re imagining just to make a simple example if there was a three-point upfront fee on a ten year note, we would pick up 30 basis points more yield than the stated rate.

Got it. So whether it’s amortized or recognized more upfront depends on the actual capital that you’re lending out.

That’s correct.

Okay.

Pat, do you…

Yes, I just add on to that that last quarter we had – the other side of that is if you should sell or get out of a security that you’ve got a bucket sitting there that you’ve been amortizing and you can pick that up. So a piece of that last quarter was from that.

Right. Yeah I know you get – some of the OID acceleration with that. And just looking at looking at the second quarter as well, could you give us an indication on the timing of the originations, whether it was kind of late in the quarter and we should expect more interest income to pull through?

In a second there, it is kind of a mix. We had about $5 million or so in April, $11 million in May and then the balance in June, so in late June though we did have $5 million that Lincoln Park piece. So somewhat mixed through the quarter, so nothing – I don’t know there’s anything telling in there quite frankly.

It seems pretty spread out across the month…

Yes…

And I guess just in terms of capital structure and leverage, you now have debt to assets slightly over the 30% which is where you guys have indicated you want to be, you could push it up a few percent. Is the current environment of addressable opportunity is one and which you would be willing to push the revolver balance up a little more and do some more portfolio growth funding or is this where you’re looking to de-lever from?

I think this is where we want to be and it’s not a question of opportunity, there’s definitely opportunity. We always worry and we’re just a conservative shop that let’s say the – even though every day is a new stock market high imagine that, but what happens if it is stops and what happens if the marks in the industry come off, that very quickly that 30% with nothing else changing not a single credit issue just marks change could become 31%, 32%, 33% we could violate the test. So given that the general view, we have the market value of the stock market and fixed income being near highs are all time tights and spread. There’s more risk of it in widening or going down and going up just academically. So we’d rather leave the cushion. That’s why we’ve always targeted point three and we’d rather just not ever come close to the limit.

Right, now that makes sense definitely. Thanks for taking my questions.

Of course.

[Operator Instructions]

It appears that we have no further questions. I will turn it back over to management for any closing remarks.

Thank you, operator. On behalf of the entire management team and our board of directors, I thank you for your continued support at StoneCastle Financial and enjoy the rest of the summer and we will see you next quarter.

Ladies and gentlemen, this does conclude our teleconference for today. We thank you for your time and participation and you may disconnect your lines at this time. Have a wonderful rest of the day.